Box Spread (Long Box)

[Igor 10]

Traders who implement a box spread or long box strategy are taking advantage of overpriced assets by instantly liquidating (arbitraging) them to fair market value. The technique involves simultaneously entering a bull call and a bear put spread, using options with parallel strike prices. Traders can earn risk-free profit, as long as the expiration value of the box exceeds the cost to enter the spread.Moneyness Review for Puts and Calls

 

Call Options:

 

In-The-Money (ITM) = Strike price (less than) Market Price

Out-of-The Money (OTM) = Strike price (more than) Market Price

 

Put Options:

 

In-The-Money (ITM) = Strike Price (more than) Market Price

Out-of-The Money (OTM) = Strike Price (less than) Market Price

 

Both Put and Call Options:

 

At-The-Money (ATM) Strike Price (equals) Market Price

 

How To Set Up A Box Spread Strategy

 

 

Disney stock is worth $45 (market price) in June.

Entering the Bull Call Spread

1) The trader writes (sells) a call option: DISJan50($1)

- 100 shares of Disney stock

- Strike Price $50 (OTM), expiring in 30 days

- Premium Cost of $1

2) The trader buys a call option: DISJan40($6)

- 100 shares of Disney stock

- Strike Price $40 (ITM), expiring in 30 days

- Premium Cost of $6

3) The trader pays a total of $500 to enter the bull call spread [$600 (paid for call purchase) - $100 (received from call sale)]

Entering the Bear Put Spread

1) Trader writes (sells) a put option: DISJan40($1.50)

- 100 shares of Disney stock

- Strike Price $40 (OTM), expiring in 30 days

- Premium Cost of $1.50

2) Trader buys a put option: DISJan50($6)

- 100 shares of Disney stock

- Strike Price $50 (ITM), expiring in 30 days

- Premium Cost of $6

3) The trader pays a total of $450 to enter the bull call spread [$600 (paid for call purchase) - $150 (received from call sale)]

Total cost to enter the market (Box Spread Strategy): $950 [$500 (cost of bull spread) + $150 (cost of bear spread)]

Computing Expiration Value

To earn risk-free profit, the expiration value of the box must exceed the cost to enter the box spread. The expiration value is simply the difference between the higher and lower strike prices, multiplied by 100. This example's box spread expiration value is $1000 [$1000= $50 (high) -$40 (low) X 100], which is higher than the $950 cost to enter the market.

 

Result one: Disney stays at $45 (ATM) in July.

a) Both the put and call options sold expire worthless (OTM).

b) The call option purchased is ITM. The trader exercises his or her right to buy 100 shares at $40, pays $4000 to the seller.

c) The put option purchased is ITM. The trader exercises his or her right to sell the 100 shares at $50, receives $5000 from the seller.

d) The trader's profit is $50 after subtracting the cost to enter the market from the gain. [$50 = $5000 (received from put sale) - $4000 (paid to call seller) - $950 (cost to enter market)]

 

Result two: Disney rallies to $50 in July.

a) Both the put and call options sold expire worthless (OTM).

b) The call option purchased is ITM. The trader exercises his or her right to buy 100 shares at $40, pays $4000 to the seller.

c) The put option purchased is ITM. The trader exercises his or her right to sell the 100 shares at $50, receives $5000 from the seller

d) The trader's profit is $50 after subtracting the cost to enter the market from the gain. [$50 = $5000 (received from put sale) - $4000 (paid to call seller) - $950 (cost to enter market)]

e) The trader's profit is $50 after subtracting the cost to enter the market from the gain. [$50 = $5000 (received from put sale) - $4000 (paid to call seller) - $950 (cost to enter market)]

 

Result three: Disney falls (crashes) to $40 in July.

a) The put and call options sold expire worthless (OTM), as well as the call option purchased.

b) The put option purchased is ITM.

c) The trader buys 100 Disney shares in the open market, paying $4000

d) The trader sells the 100 shares to the writer at $50, receiving $5000 from the seller.

e) The trader's profit is $50 after subtracting the cost to enter the market from the gain. [$50 = $5000 (received from writer) - $4000 (paid for shares) - $950 (cost to enter market)]

 

Advantages and Disadvantages of Implementing a Box Spread Strategy:

 

Pluses: The upside to this type of strategy is that the investor will always make a small profit in any market situation, risk-free. The trader is just settling the overpriced options to fair market value.

 

Minuses: There is no downside in carrying out a box spread strategy, since it risk-free. However, traders must be able to quickly recognize options with expiration values that exceed the investment's costs.

[Tams 20]

the broker would love you

[FoamPeanut 10]

The problem with a box spread is that you've got to be careful of dividends. Most of the stocks on which a box spread appears to be profitable will typically have some dividend event before expiration. With an upcoming dividend, it's one of the few times it makes sense for the market maker to exercise his long call. All of the sudden you're short the stock and owe a dividend payment, so in order for the box spread to be profitable, the premium you get from entering into the position should also take into account any dividend payments.

 

In addition, most of the stocks on which this appears to work will also be thinly traded. In thinly traded issues, the exchange, or your broker, can impose (I forget the exact name) short position limits requiring you to liquidate your otherwise profitable short position. In other words, you can get a margin call on your short, even though it's in the black.