Short Box

[Igor 10]

Traders who implement a short box strategy are taking advantage of overpriced assets by instantly liquidating (arbitraging) them to fair market value. The technique involves selling both a bull call and bear put spread at the same time, using options with parallel strike prices and expirations. Traders can earn risk-free profit, as long as the credit received when entering the market exceeds the expiration value of the box.

 

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 Short Box Strategy

 

 

Disney stock is worth $55 (market price) in July.

Selling the Bull Call Spread

1) The trader writes (sells) a call option: DISAug50($7)

- 100 shares of Disney stock

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

- Premium Cost of $7

2) The trader buys a call option: DISAug60($1.50)

- 100 shares of Disney stock

- Strike Price $60 (OTM), expiring in 30 days

- Premium Cost of $1.50

3) The trader receives a credit of $550 when entering the bull call spread. [$700 (received from call sale) - $150 (paid for call purchase)]

Selling the Bear Put Spread

1) Trader writes (sells) a put option: DISAug60($7)

- 100 shares of Disney stock

- Strike Price $60 (ITM), expiring in 30 days

- Premium Cost of $7

2) Trader buys a put option: DISAug50($2)

- 100 shares of Disney stock

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

- Premium Cost of $2

3) The trader receives a credit of $500 when entering the bear put spread. [$700 (received from put sale) - $200 (paid for put purchase)]

Total (Short Box) credit when entering the market $1050: [$550 (credit from bull spread) + $500 (credit from bear spread)]

Computing Expiration Value

To earn risk-free profit, the credit received when entering the market must exceed the expiration value of the box. 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= $60 (high) - $50 (low) X 100], which is lower than the $1050 credit when entering the market.

 

Result one: Disney stays at $55 (ATM) in August.

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

b) The put option sold is ITM The buyer exercises his or her right to sell the trader 100 shares at $60. The trader pays $6000 to the seller.

c) The call option sold is ITM. The buyer exercises his or her right to buy shares at $50 from the trader, who sells the 100 shares and receives $5000 from the buyer.

d) The trader's profit is $50 after adding the credit received when entering the market from the loss. [$50 = $5000 (received from call buyer) - $6000 (paid to put buyer) + $1050 (credit)]

 

Result two: Disney rallies to $60 in August.

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

b) The call option sold is ITM.

c) The trader buys 100 Disney shares in the open market to cover the sale, paying $6000.

d) The buyer exercises his or her right to buy shares at $50 from the trader, who sells the 100 shares and receives $5000 from the buyer.

e) The trader's profit is $50 after adding the credit received when entering the market from the loss. [$50 = $5000 (received from call buyer) - $6000 (paid for shares) + $1050 (credit)]

 

Result three: Disney falls (crashes) to $50 in August.

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

b) The put option sold is ITM.

c) The buyer exercises his or her right to sell the trader 100 shares at $60. The trader pays $6000 to the seller.

d) The trader sells 100 Disney shares in the open market at $50 and receives $5000.

e) The trader's profit is $50 after adding the credit received when entering the market from the loss. [$50 = $5000 (received from put buyer) - $6000 (share sale) + $1050 (credit)]

 

Advantages and Disadvantages of Implementing a Small Box 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 arbitraging the overpriced options to fair market value.

 

Minuses: There is no downside in carrying out a short strategy, since it risk-free. However, traders must be able to quickly recognize options with overpriced expiration values.