A box spread is strategically employed when the price of the combined spreads is below their intrinsic value at expiration. Conversely, if the market has priced these spreads too high, a trader might utilize a short box, which involves entering opposite positions compared to the long box.
This strategy is aptly named for the structural analogy it draws from the shape of a box, as it comprises two vertical spreads: a bull call spread and a bear put spread.
The strategy involves creating a synthetic long and a synthetic short position on the same asset to lock in a risk-free profit.
The Structure of a Box Spread
A box spread consists of four different options contracts, which form the sides of the “box”:
Buy a Call (Lower Strike):
Action: Purchase an in-the-money call option.
Purpose: This represents one side of the box, establishing a synthetic long position at the lower strike price.
Sell a Put (Lower Strike):
Action: Sell an in-the-money put option at the same strike price as the call bought.
Purpose: This completes the synthetic long position and is the second side of the box.
Sell a Call (Higher Strike):
Action: Sell an out-of-the-money call option at a higher strike price.
Purpose: This initiates the synthetic short position and forms the third side of the box.
Buy a Put (Higher Strike):
Action: Purchase an out-of-the-money put option at the same strike price as the call sold.
Purpose: This completes the synthetic short position, finalizing the four sides of the box.
Ideal Conditions for a Box Spread
Pricing Inefficiencies: The Box Spread is most effective in a market with pricing inefficiencies between options premiums and their intrinsic values.
Low Transaction Costs: Because the profit from a box spread is often small, low transaction costs are crucial to ensure the strategy remains profitable.
Profit and Loss Dynamics
Risk-Free Arbitrage: In theory, the box spread is intended to produce a risk-free profit if the price discrepancy exists.
Maximum Profit: The fixed profit from a box spread is determined at the outset and is the difference between the two strike prices minus the net cost of establishing the spread.
Maximum Loss: Because this is an arbitrage strategy, there shouldn’t be a loss if the box spread is executed correctly and the options are priced fairly. However, transaction costs and mispricing can lead to losses.
A box spread isn’t about reaching a breakeven at expiration like most options strategies; it’s about locking in a guaranteed return right from the start.
Execution and Risks
Interest Rates: The risk-free rate of return is a factor in the pricing of options used in a box spread, so changes in interest rates can affect the profitability of the strategy.
Dividends: If the underlying asset pays dividends, it can affect option prices and the profitability of the box spread.
Liquidity: Execution risk can occur if there isn’t enough liquidity in the market, potentially leading to slippage and affecting the expected profit.
Key Insights on Box Spreads
Strategic Combination: A box spread is constructed by integrating a bull call spread with a corresponding bear put spread.
Predictable Outcome: The payoff from a box spread is predetermined and is equivalent to the difference between the strike prices of the options involved.
Time Value and Pricing: The market value of a box spread today is inversely related to the time remaining until expiration—the longer the time frame, the lower the current market price.
Implementation Costs: The expenses incurred, especially brokerage commissions, can significantly impact the overall profitability of a box spread.
Synthetic Financial Instrument: Traders may also utilize box spreads for cash management objectives, as they can serve as a synthetic means of borrowing or lending funds.
The Box Spread is a sophisticated strategy that can be used to lock in profits through arbitrage opportunities in options pricing. While it is theoretically a risk-free strategy, practical considerations such as transaction costs, liquidity, and the timely execution of trades can introduce risks.
Box Spread Example
NIFTY Bank is trading at 46150.
Buy the ITMs
Buy 46200PE at 490 (ITM)
Buy 46100CE at 514.05 (ITM)
Sell the OTMs
Sell 46200CE at 468.8 (OTM)
Sell 46100PE at 422.9 (OTM)
The total cost of the trade before commissions is calculated as follows:
= (Debit for buying 46200PE) + (Debit for buying 46100CE) – (Credit for selling 46200CE) – (Credit for selling 46100PE)
= 490 + 514.05 – 468.8 – 422.9
= 1004.05 – 891.7
= 112.35 points
The lot size is 15. So, the total cost is 112.35 * 15 = 1685.25 INR.
The spread between the strike prices remains 100. Given the lot size of 15, the value of the box spread before commissions is:
Box spread value = 100 * 15
Box spread value = 1500 INR
= Intrinsic Value of the Spread-Total Setup Cost
= 1500 INR – 1685.25 INR
= – 185.25 INR
This loss of 185.25 INR represents the guaranteed shortfall from the box spread strategy before any commissions are applied.
It means sure shot loss. The payoff graph looks like –
Since the total cost to set up the box spread exceeds the maximum possible return from the spread itself, the strategy ensures a locked-in loss under these conditions.