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What Is A Box Spread In Options Trading?

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by Gavin in Blog
January 30, 2021 0 comments

Contents

A box spread is an options trading strategy that enables traders to profit from arbitrage.

Arbitrage is the process by which a profit is derived by taking advantage of differences in price for identical or similar assets on different markets or different forms.

To execute a box spread, a trader would use both a bull call spread and a bear put spread, with the same expiration dates and the same strike prices.

If executed correctly, traders can make an arbitrage profit when the spreads are underpriced in relation to their expiration values.

This article will break down the box spread, covering what is a spread, how the box spread is formed, and how to use it in your trading.

What Is A Spread? 

Simply put, a spread is when a trade derives value from the difference in prices between two or more assets.

For example, if you were to sell a stock at $60, whilst buying the same stock at $50, your spread would be $10.

You can do the same thing with options, selling an option contract to offset the price of purchasing a similar option contract that’s nearer to the money.

By adopting this approach, a trader can reduce the level of risk they take on when purchasing an options contract.

The disadvantage is that the potential profit from the position is limited due to the act of simultaneously selling an option.

Spreads can be achieved in either direction (i.e. bullish or bearish) through the use of call options or put options.

What Is A Box Spread? 

A box spread is a special type of spread that relies on favorable option pricing to provide a risk-free arbitrage opportunity.

A box spread involves simultaneously executing both a bull call spread and a bear put spread.

Since the trader is using two spreads that offset each other, an arbitrage profit is made when the value exceeds the total cost of the premiums.

For example, say that ABC company is currently trading at $55 and you spot an opportunity to profit from a box spread.

You execute the first part of the box spread (the bull call spread) by buying a call option with a $50 strike price, whilst simultaneously selling a call option with a $60 strike price.

Then, you execute the second part of the box spread (bear put spread) by buying a put option with a $60 strike price, whilst simultaneously selling a put option with a $50 strike price.

The cost of each contract is as follows:

  • 50 call: $5.00
  • 60 call: $1.40
  • 50 put: $1.10
  • 60 put: $5.00

So your premiums come out to be:

  • Bull Call Spread: $500 – $140 = $360
  • Bear Put Spread: $500 – $110 = $390
  • Total Premium Paid $360 + $390 = $750

Meanwhile, the expiration value of the box spread is $1,000: ($60 – $50) * 100.

Therefore, if the two spreads cost us $750 and the expiration value is $1,000, we have made a risk free profit of $250 and just have to wait until expiration to achieve the full profit.

We’ll look at several possible scenarios:

Scenario 1: ABC doesnt change ($55 on the expiration date)

Both the 50 put and the 60 call expire worthless.

Both the 50 call and 60 put expire in-the-money, with an intrinsic value of $500 each.

Therefore, the total value of the box at expiration is $1,000 ($500 + $500).

Subtract the cost of $750 and we have a profit of $250.

Scenario 2: ABC appreciates in value and is $60 on the expiration date

In this scenario, three options expire worthless and only the 50 call will expire in-the-money.

The intrinsic value is equal to $1,000 ($10 x 100).

Therefore, the total value of the box at expiration is equal to the intrinsic value of the 50 call, namely $1,000.

Subtract the cost of $750 and we have a profit of $250.

Scenario 3: ABC falls in value and is $50 on the expiration date

In this scenario, once again three options expire worthlessly.

Only the 60 put expires in-the-money, with an intrinsic value equal to $1,000 ($10 x 100).

Similar to scenario 2, the total value of the box at expiration is equal to the intrinsic value of the 60 put, namely $1,000.

Subtract the cost of $750 and we have a profit of $250.

Scenario Outcomes 

As you can see from the three scenarios, no matter what happened to the price of ABC stock, the total value of the box at expiration was always $1,000 with a profit of $250.

In this example we ignored commissions however, given you must buy/sell four options, commissions can very quickly eat away some or all of your profits.

The box spread is sometimes jokingly called the alligator spread for this very reason, so make sure you calculate all your costs upfront, including premiums and commissions, before executing the trade.

While it’s possible to spot these opportunities yourself, doing so can be very difficult due to the mental calculations required.

It’s best to use a software program that can provide signals coupled with automated price analysis, to quickly spot and capitalize on any opportunities.

Also, with the advent of computerized trading, these types of opportunities are few and far between.

Those that do occur are very quickly snapped up by advanced computer algorithms, making it almost impossible for the average retail trade to profit from box spreads.

Conclusion 

Box spreads enable traders to make a risk-free profit by using arbitrage.

It involves simultaneously executing a bull call spread and a bear put spread with the same strike prices and expiration.

Provided that the total value of the box spread exceeds the cost in premiums and commissions paid, the trader is assured of a risk-free profit as it doesn’t matter in which direction the underlying stock price moves.

Finding box spread opportunities is best completed with the aid of software that can provide signals and automate the price analysis.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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