What is the Box Spread Options Trading Strategy?
Options trading is a lucrative yet risky investment avenue. The risk, as well as rewards involved in Options, tend to be higher. However, low-risk option strategies reduce or eliminate the risk involved in Options trading. Box spread strategy is an arbitrage opportunity that involves combining multiple Options to execute a risk-free trade. Here’s everything you need to know about this strategy.
What is a Box Spread Options Strategy?
The Box spread options strategy involves combining a bull call spread with a bear put spread to create a market-neutral position. The strike price and expiry dates for both spreads are the same. The Box spread involves executing four trades simultaneously. Let’s consider the following box spread option strategy example.
The current market price of a stock in June is Rs. 55. July 50 Call is available at a premium of Rs. 6 whereas July 60 Call trades at a premium of Re. 1. The premium for July 50 Put and July 60 Put Options is Rs. 1.50 and Rs. 6 respectively. The lot size is 100 shares.
To execute a box spread, the trader will purchase an in-the-money call and put options. At the same time, the trader will sell out-of-the-money calls and puts. The following trades are executed:
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A Bull call Spread involves purchasing July 50 Call and selling July 60 Call. The bull call spread cost is the difference between the premium received and the premium paid i.e. Rs. (6-1) per share. Thus, the total cost is Rs. 500 for one lot.
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Bull put Spread entails purchasing July 60 Call and selling July 50 Call. The cost for the bear put spread is the difference between the premium received and the premium paid i.e. Rs. (6-1.5) per share. Thus, the total cost is Rs. 450 for one lot.
Thus, the total cost for the box spread is the sum of the bull call spread and bear put spread of Rs. 950.
The value of the box spread on expiry is (Rs. 60 – Rs. 50) per share or Rs. 1000 for the lot. The current value of the box spread is lower than the value at expiry. Therefore, the box spread will be profitable for the trader. The Net profit will be the difference between the value at expiry and the total cost which is Rs. 50.
Scenario 1 – The stock price of Rs. 55
The stock price on expiry remains unchanged at Rs. 55. In this case, July 60 Put and the July 50 Call expires worthlessly, whereas July 50 Call and the July 60 Put expire in the money with an intrinsic value of Rs. 500 each. Thus, the total intrinsic value of the box spread at expiry is Rs. 1000.
Hence, the profit is the difference between the intrinsic value and total cost which is equal to Rs.50.
Scenario 2 – The stock price of Rs. 60
The stock price on expiry increases to Rs. 60. All options expire worthless except the July 50 Call Option. The July 50 Call Option expires in the money with an intrinsic value of Rs. 1000. The intrinsic value of the box is Rs. 1000. Consequently, the profit is the difference between the intrinsic value and the total cost of Rs.50.
Scenario 3 – The stock price of Rs. 50
The stock price on expiry reduces to Rs. 50. All Options expire worthless except the July 60 Put Option. The July 60 Put Option expires in the money with an intrinsic value of Rs. 1000. The intrinsic value of the box is Rs. 1000. Consequently, the profit is the difference between the intrinsic value and total cost which is equal to Rs.50.
In conclusion, the total profit from the box strategy remains constant at Rs. 50 whereas the intrinsic value in each scenario is also restricted to Rs. 1000.
When should you use Box Spread Option Strategy?
The objective of the box spread is to earn a risk-free profit. The quantum of profit in box spread may be limited. Box spread is best suited when the spreads are undervalued for their value on expiration. Being a market-neutral strategy, the price movement of the underlying does not have any impact on the box spread.
Box spread is an advanced strategy that requires professional management. It may not be the best option for retail investors. The price movements of box spread are to be monitored closely. Secondly, box spread requires high maintenance of margins and brokerage commissions. Due to lower profit margins, only low-fee traders benefit from the box spread strategy.
Risks and Rewards associated with Box Spread?
Box spread is an arbitrage opportunity that is a risk-free or low-risk strategy. The overall risk is limited since the loss in one spread is set off against the gain from another spread. The ancillary risk from the strategy may include the cost of transacting. Since box spread involves multiple option trades, the transaction cost is high. Thus, the trader must ensure that the profit from the trade is higher than the cost of transacting.
The rewards from the box spread are predetermined and limited. It is the difference between the total cost of the box spread and its value at expiry. The rewards from a box spread are higher than interest earnings from fixed deposits whereas the risk involved is similar. Hence, box spread acts as an alternative for investors with a lower risk appetite.
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Frequently Asked Questions
The box spread is a delta neutral strategy since the trader purchases and sells equivalent spreads. As long as the cost for the box is considerably lower than the combined value of the spread on expiration, you earn a riskless profit.
Box spread is a low risk and low return investment opportunity. However, there may be challenges in practically executing a box spread. Trades may be difficult to fill since the arbitrage opportunity tends to be available for shorter time frames.
Box spread strategy is profitable in cases where the intrinsic value is greater than the cost of the spread. However, the cost of trading such as brokerage, commissions, taxes, etc. may increase the overall cost of the transaction and reduce or wipe out gains from the strategy.