Definition of Box Spread
A box spread is basically a concept from options trading format, wherein there are a combination of positions entered into in such a way that it entails buying a bull (long) call spread and hedging the same against a matching bear (short) put spread and requires a certain amount of payoff to create a neutral interest rate position in the market.
In simple terms, box spread can be referred to as an arbitrage strategy entered by traders by way of buying a call spread along with a put spread. In such an arrangement, the difference in both these spreads will be the net payoff for the box spread.
In needs to be highlighted that every trade or transaction entails a commission. Similarly, even in box spread trading there will be commissions charged and it becomes of utmost importance to consider the same while arriving at a profit, when entering into box spreads.
How Does It Work?
To explain the whole box spread concept, it needs to be understood that this is an arbitrage strategy that involves you to buy an In The Money (ITM) call and put and simultaneously sell and Out The Money (OTM) call and put.
With this strategy, the trader aims to achieve a risk-free profit, provided the commissions on buying and selling the option contracts is lesser than the profit derived.
Example of Box Spread
Lets’ take an example to understand the concept a little better.
Suppose, Amazon Inc. stocks are currently trading at a price of $100. Further, consider that each leg of the box is for 100 stocks. Based on below given box spread strategy, find out the estimated profitability of the box spread.
- Buy ITM call of 99 @ 400 per option contract
- Sell OTM call of 105 @ 90 per option contract
- Buy ITM put of 105 @ 200 per option contract
- SellOTM put of 99 @ 80 per option contract
First let us find out the cost incurred in this box spread. Total cost before any commission will be: $400 – $90 + $200 – $80 = $430. The strike prices spread will be $105 – $99 = $6, therefore per contract the spread will be $6*100 = $600.
Based on the above calculation, we can see that the box spread gives us a profit of $170 (before commissions). Assuming commissions to be $10 per contract, the net profit we will receive will be $130.
|Strike Price||Call||Put||Spread||Strike Price Spread|
|Commission @ $10 per contract||40|
Box Spreads in Futures Trading
Futures trading is basically a contract or agreement to buy or sell a stock or commodity or an underlying asset at a future date at a predetermined price. Box spread can be equally applied to the future as well, however, it is said that in the case of futures trading, prices don’t really to a significant extent. Futures mostly have a range and move in that range. Accordingly, the strategy needs to be moulded for futures trading.
Since options are more volatile, you see that lot of traders generally apply a box spread strategy in options trading as compared to futures trading.
Risk of Box Spread
On the face of it, box spread definitely looks risk free. Here’s the catch. It is not really risk free, certain concerns attached with the box spread strategy are given below.
- Box spread strategies entail entering into four positions which means you end up paying commissions on all four contracts that you need to enter into. Furthermore, you need to make sure that the profits that you earn at least cover the amount of commission and charges you pay before you can call in a profit.
- In case you go for short option positions, remember there is always a risk of early assignment. In a box spread, you have two short positions. Thus, the risk of early assignment and possible additional charges from your broker.
- Knowledge plays a very important role in planning a box spread strategy. Until and unless you are a seasoned and well-versed trader, be prepared to handle lots of difficulties in handling such spreads.
- Time and timing concerns. The arbitraging opportunities last for hardly few seconds literally and maybe a few minutes. You need to be really quick to plan a spread and execute it well to earn a profit out it.
Box Spread Graph
Continuing from the above example, we will show you the box spread in a graph format for a visual understanding.
We can see that the strike of $100 is shown by the yellow circle. Now, as the strike price moves, the values of call and put options will keep on changing, and accordingly, the profit will change.
Considering that the trader will buy the call and put option, any upward movement in strike price will entail a positive movement in the call option whereas any downward movement in the strike price will entail a positive movement in the put option. Thus, this strategy will enable the trader to arbitrage and eventually earn some profit out of the trade.
There are certain benefits that are achieved with the use of box spread as listed below:
- Risk free profit
- Expiry value is better than spread value
- The direction in which the stock price moves doesn’t affect the strategy
- The strategy is neutral from delta perspective
- Chances of incurring loss is very minimal
Some of the disadvantages are given below:
- Minimal profits earned
- Huge amounts go in commissions
- Experience of markets and its knowledge required
- Buying options requires to maintain margin money
- A huge amount of money is blocked in holding the positions
This is a guide to Box Spread. Here we also discuss the definition and how does box spread work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –
- Simple Interest Rate vs Compound Interest Rate
- Dividend Growth Rate
- Times Interest Earned Ratio
- Bond vs Loan