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Box Spread (Arbitrage) Options Trading Strategy Explained

Published on 4/19/2018 1:41:10 AM | Modified on Tuesday, May 29, 2018

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Box Spread (Arbitrage)
Box Spread (Arbitrage) Options Strategy
Strategy LevelAdvance
Instruments TradedCall + Put
Number of Positions4
Market ViewNeutral
Risk ProfileNone
Reward ProfileLimited
Breakeven Point

Box Spread (also known as Long Box) is an arbitrage strategy. It involves buying a Bull Call Spread (1 ITM and I OTM Call) together with the corresponding Bear Put Spread (1 ITM and 1 OTM Put), with both spreads having the same strike prices and expiration dates.

The strategy is called Box Spread as it is combination of 2 spreads (4 trades) and the profit/loss calculated together as 1 trade. Note that the total cost of the box remain same irrespective to the price movement of underlying security in any direction. The expiration value of the box spread is actually the difference between the strike prices of the options involved.

The Long Box strategy is opposite to Short Box strategy. It is used when the spreads are under-priced with respect to their combined expiration value.

The usual box spread look like as below for NIFTY current index value as 10550 (NIFTY Spot Price):

Box Spread Orders
OrdersNIFTY Strike Price
Bull Call SpreadBuy 1 ITM CallNIFTY18APR10400CE
Sell 1 OTM CallNIFTY18APR10700CE
Bear Put SpreadBuy 1 ITM PutNIFTY18APR10700PE
Sell 1 OTM PutNIFTY18APR10400PE

Note:

  • Call Spread meaning 2 calls, one ITM and one OTM.
  • Put Spread meaning 2 puts, one ITM and one OTM.
  • ITM is 'In the money' and OTM is 'Out of the money'. For Nifty Spot Price at 10550, the 10400 Call Option is ITM and 10700 Call is OTM.
  • Arbitrage strategy is a way to earn small profits with very little or zero risk. In this a trader buys the call and put have the same strike value and expiration The resulting portfolio is delta neutral.

As you see in the above table, this is a delta neutral strategy. The trader is buying and selling equivalent spreads. As long as the price paid for the box is significantly below the combined expiration value of the spreads, a riskless profit can be earned. We will discuss this in detail in an example below.

As the profit from the box spread is very small, the brokerage and taxes involved in this strategy can sometimes offset all of the gains. It's very important to consider the trading cost (brokerage, fee, taxes etc.) before trading in this strategy.

When to use Box Spread (Arbitrage) strategy?

Being risks free arbitrage strategy, this strategy can earn better return than earnings in interest from fixed deposits. The earning from this strategy varies with the strike price chosen by the trader. i.e. Earning from strike price '10400, 10700' will be different from strike price combination of '9800,11000'.

The long box strategy should be used when the component spreads are underpriced in relation to their expiration values. In most cases, the trader has to hold the position till expiry to gain the benefits of the price difference.

Note: If the spreads are overprices, another strategy named Short Box can be used for a profit.

This strategy should be used by advanced traders as the gains are minimal. The brokerage payable when implementing this strategy can take away all the profits. This strategy should only be implemented when the fees paid are lower than the expected profit.

Example

Box Spread Example 1

Let's take a simple example of a stock trading at ₹45 (spot price) in June. The option contracts for this stock are available at the following premium:

  • July 40 call - ₹6
  • July 50 call - ₹1
  • July 40 put - ₹1.50
  • July 50 put - ₹6

Lot size: 100 shares in 1 lot

  1. Buy a Bull Call Spread = Buy 'July 40 call' + Sell 'July 50 call'

    Bull Call Spread Cost = (₹6*100) – (₹1*100) = ₹500

  2. Buy Bear Put Spread = Buy 'July 50 put' + Sell 'July 40 put'

    Bear Put Spread Cost = (₹6*100) – (₹1.50*100) = ₹450

The total cost of the box spread is: ₹500 + ₹450 = ₹950

The expiration value of the box is computed to be: (₹50 - ₹40) x 100 = ₹1000

Since the box spread value is lower, the Long Box strategy can be used hear for risk free profits.

Profit: ₹1000 - ₹950 = ₹50

Net Profit = ₹50 - Brokerage - Taxes

In above example, since the total cost of the box spread is less than its expiration value, a risk-free arbitrage is possible with the long box strategy. Now let's discuss about the possible scenarios:

Scenario 1: Stock price remain unchanged at 45

The July 40 put and the July 50 call expire worthless while both the July 40 call and the July 50 put expires in-the-money with ₹500 intrinsic value each. So the total value of the box at expiration is: ₹500 + ₹500 = ₹1000.

Scenario 2: Stock price reaches to 50

Only the July 40 call expires in-the-money with ₹1000 in intrinsic value. So the box is still worth ₹1000 at expiration.

Scenario 3: Stock price falls to 40

A similar situation as scenario 2 happens but this time it is the July 50 put that expires in-the-money with ₹1000 in intrinsic value while all the other options expire worthless. Still, the box is worth ₹1000.

In all the possible scenarios, the box worth remains at ₹1000 on expiry resulting in profit of ₹50.

Box Spread Example 2

Let's take an example of NIFTY Options which is traded in lot size of 75.

Box Spread Example for NIFTY Options
Strike PricePremium (₹)Premium Paid (₹)
(Premium * Lot Size of 75)
Bull Call SpreadBuy 1 ITM Call10400187.7014077.50
Sell 1 OTM Call10700-14.00-1050.00
Bear Put SpreadBuy 1 ITM Put10700145.5510916.25
Sell 1 OTM Put10400-24.95-1871.25
Total22072.50
Bull Call Spread Cost=(14077.50-1050.00)13027.50
Bear Put Spread Cost=(10916.25-1871.25)9045.00
Total Box Spread Cost22072.50
Expiration value of the box=(10700-10400)*7522500
Profit=(22500-22072.50)427.5
Brokerage + Taxes=8 trades * ₹20 + taxes₹200
Net Profit₹227.5 (1.03%)

Note the Net Profit changes when you buy options at different the strike price using the same strategy.

Market View - Neutral

The market view for this strategy is neutral. The movement in underlying security doesn't affect the outcome (profit/loss). This arbitrage strategy is to earn small profits irrespective of the market movements in any direction.

Actions

  • Buy Call Option 1
  • Sell Call Option 2
  • Buy Put Option 1
  • Sell Put Option 2 (2>1)

Say for XYZ stock, the component spreads are underpriced in relation to their expiration values. The trader could execute Long Box strategy by buying 1 ITM Call and 1 ITM Put while selling 1 OTM Call and 1 OTM Put. There is no risk of loss while the profit potential would be the difference between two strike prices minus net premium.

Risk Profile of Box Spread (Arbitrage)

None

The Box Spread Options Strategy is a relatively risk-free strategy. There is no risk in the overall position because the losses in one spread will be neutralized by the gains in the other spread.

The trades are also risk-free as they are executed on an exchange and therefore cleared and guaranteed by the exchange.

The small risks of this strategy include:

  1. The cost of trading - Some brokers charges high brokerage/fees, which along with the taxes could make the overall loss-making trade.
  2. The box spread can be liquidated by an offsetting transaction easily and transparently on an exchange with minimal loss/profit.

Reward Profile of Box Spread (Arbitrage)

Limited

The reward in this strategy is the difference between the total cost of the box spread and its expiration value. Being an arbitrage strategy, the profits are very small.

It's an extremely low-risk options trading strategy.

Advantage of Box Spread (Arbitrage)

  1. This is an Arbitrage strategy. This strategy is to earn small profits with very little or zero risks.

Disadvantage of Box Spread (Arbitrage)

  1. It's a professional strategy and not for retail investors. The opportunities are closely monitored by High-Frequency algorithms. These arbitrage opportunities are usually for the high-frequency algorithms and need large pools of money to make it worth it and usually with better brokerage commission schemes.
  2. This strategy has high margin maintenance requirements and in many cases, the trader won't have the margin available to do that.
  3. For retail investors, the brokerage commissions don't make this a viable strategy. Only low-fee traders can take advantage of this.
  4. In theory, this strategy sounds good but in reality, it may not as profits are small.
  5. Locking the box - Trader has to wait until to expiry by keeping the money stuck in the box.

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