Finance

What is Box Spread Option Strategy?

Box Spread also known as Long Spread is an arbitrage strategy wherein two simultaneous buying positions (put and call) are taken in both bear and bull markets whose strike rates and expiry dates are the same. It helps in balancing risks because the shortcomings of one position are countered by that of the other, therefore it is also known as delta neutral strategy. The commissions charged by the brokers for carrying out this strategy are very high which may lead to no profit or sometimes loss as well. The difference between the two spreads is known as a box spread payoff.

How does it work?

We will try to understand the concept with an example:

Let us consider that shares of HR Enterprises were traded at Rs. 55 per share in August 2019. The option contracts are available at premium for this stock at:

Sept 50 call- Rs 8

Sept 60 call- Rs 3

Sept 50 put- Rs 3.50

Sept 60 put- Rs 8

1 lot has 100 shares

Bull call Spread = Buy ‘Sept 50 call’ + Sell ‘Sept 60 call’

Bull call Spread costs = ‘Sept 50 call’ – ‘Sept 60 call’

= (8*100) -(3*100)

=800-300

= Rs 500

Bear put Spread= Buy ‘Sept 60 put’ + Sell ‘Sept 50 put’

Bear put Spread costs = ‘Sept 60 put’ – ‘Sept 50 put’

= (8*100) – (3.5*100)

= 800-350

= Rs 450

= Rs 500 + Rs 450

= Rs 950

Expiration Value = (Rs 60- Rs 50) * 100

= 10 * 100

= Rs 1000

In order to earn risk free profits, Long box strategy can be used since box spread value is lower.

Profit = Expiration Value – Cost of Box Spread

= Rs 1000- Rs 950

= Rs 50

Net Profit would be Profit less brokerage less taxes.

In order to exercise risk-free arbitrage, we will look at different scenarios:

• If the price is constant: Sept 60 call & Sept 50 put will have no value at expiration, but the box value will be Rs 1000 as Sept 50 call & Sept 60 put will have a value of Rs 500 each at expiration in the market.
• If the price reaches Rs 60: The box value remains unchanged at this point because only Sept 50 call expires in the market at an intrinsic value of Rs 1000.
• If the price falls Rs 50:  The box is still worth Rs 1000 as all the options will expire worthless except for the Sept 60 put that will have an intrinsic value of  Rs 1000 on expiry in the market. The profit amount of Rs 50 remains the same as the box value for all the scenarios is the same.

Pros and Cons:

Pros:

1.  It is a risk-free arbitrage strategy so no loss arises.
2.  The risk factor is very low, sometimes even zero so it helps in earning small profits.
3.  It is a delta neutral strategy as fluctuations in price does not affect profits.

Cons:

1.  The profit margin is very less or sometimes nil as the brokerage commission and taxes have to be paid which are very high.
2. This strategy is complex as it requires high technical skills as it involves forming strategies using algorithms.
3. This strategy involves high margins which are not always available.
4. The maturity is only at expiry dates, so the investor has to hold the position till expiry.

Conclusion:

Box spread options strategy is a risk-free arbitrage strategy that assures profits by avoiding losses by taking 2 calls and 2 put positions in the market and so its position is neutral in the market. This strategy is complicated and is therefore mostly practiced by experts who possess expertise in taking positions because timing and price play a crucial role in estimating profits. The strategy assures sure shot profit but the only flaw is that the commissions and taxes are too high to take away all the profits.

Author: Urvi Surti

About the Author:  Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).

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