The Box Spread is a strategy where two vertical spreads (one using calls and one using puts) with opposite bias are entered in the same strike prices.
For example, On March the 9, you could have bought an SPY April 138/140 Bull Call Spread for 0.94 debit. And at the same time the 140/138 Bear Put Spread for a debit of 1.06.
Each position neutralizes each other. The total debit invested is 2.00, but there is no risk in the overall position because the losses in one spread will be neutralized by the gains in the other spread.
BUY 138/140 Bull Call Spread @0.94
BUY 140/138 Bear Put Spread @1.06
(Click on image to enlarge)
Notice the horizontal red line (which depicts profits/losses by expiration) is positioned right on the zero line, for the whole spectrum of SPY prices. So, there's in fact no risk in this position, and no possible profit either. It would be in fact dumb to play something like this as you would only be feeding your broker with commissions.
Now, why isn't there a profit? and how can a profit be obtained out of something like this?
The reason there is no possible profit is that the combined cost of the spreads 1.06 and 0.94 = 2.00 equals the width of the spread, 140-138 = 2.00 points. In fact if the pricing of options were always perfect this would always be the case: the sum of contrary spreads would equal the width of the spread.
However, sometimes this is not the case. If the combined cost of the opposite spreads is less than 2.00, on spreads like these of 2.00 range, then there is an arbitrage opportunity! Where risk free money can be made.
Let's say you could buy the 138/140 Bull Call Spread for 0.94 and the 140/138 Bear Put spread for 1.01 instead of the 1.06 it cost on March 9. In that case you would be entering the 2 point wide Box Spread for a total debit of only 1.95 and that results in a guaranteed profit of 0.05, or $5 per contract played.
BUY 138/140 Bull Call Spread @0.94
BUY 140/138 Bear Put Spread @1.01
(Click on image to enlarge)
There is now a guaranteed profit of $5 throughout the whole spectrum of possible SPY prices. The position doesn't need to be closed, you just open it with the guaranteed profit and let it get to expiration.
Exploiting this price inefficiency in reality is difficult, first you need an options friendly broker with very low commissions, as the arbitrage opportunity won't offer more than a few dollars per contract. And second, and this is the main factor, there are many computerized algorithms scanning for arbitrage opportunities like this one every second. If the price inefficiency shows up, algorithms immediately exploit it, which makes the pricing schema adjust itself to normal after a few seconds. This makes the window of opportunity very small for this type of arbitrage to be manually exploited by people.
How can you still benefit from the Box Spread?
Maybe you can't really exploit the Box Spread for opening risk free positions, due to the two factors mentioned above. But knowing the principle that make it work, you can apply that principle in other situations. You can for example lock in profits in existing positions where it is hard to exit due to liquidity issues.
The principle is simple:
The combined cost of two opposite spreads is usually equal to the width of the spreads. If this combined cost is less than the width of the spreads, there is an opportunity to lock in profits.
Let's analyze the first example where I purchase a 138/140 March Bull Call Spread for 0.94. The opposite 140/138 Bear Put Spread is worth 1.06, but I don't purchase that one. I only enter the 138/140 Bull Call spread betting that the market is going up.
BUY 138/140 Bull Call Spread @0.94
A few days later the market has moved up (in my favor) and the 138/140 Bull Call Spread is now worth 1.20. Obviously at this point, the 140/138 Bear Put spread must be trading at 0.80. If at this point I purchase the 140/138 Bear Put spread for 0.80, I would be locking the box with a guaranteed profit.
BUY 140/138 Bear Put Spread @0.80
I have invested 0.94 + 0.80 = 1.74 in a Box Spread that is 2.00 point wide, therefore I have a difference of 0.26 in my favor. The trade will now return $26 per contract at expiration and it is risk free, and there is no need to close anything, just let the whole box expire and save the commissions. There is no way to lose in this position. There is a 0.26 guaranteed profit.
Instead of creating the Box Spread, the trader could have simply sold his Bull Call Spread, which he bought at 0.94 and was trading at 1.20, and the trader would have obtained the same 0.26 profit per contract. That is true, however closing the original position becomes hard in some cases due to liquidity issues. Instruments like SPX, RUT, might be very difficult to close at times due to this reason. But, if you detect that there is more volume in the strike prices of the opposite spread or more open interest, you can decide to create the Box Spread, your fill will be easier and the Box Spread will have the same profit locking effect as if you had closed your original position.
Related Articles:
How to lock in profits on an options trade and stay in the position
Locking profits on a Vertical Spread
The Three Legged Box explained
For example, On March the 9, you could have bought an SPY April 138/140 Bull Call Spread for 0.94 debit. And at the same time the 140/138 Bear Put Spread for a debit of 1.06.
Each position neutralizes each other. The total debit invested is 2.00, but there is no risk in the overall position because the losses in one spread will be neutralized by the gains in the other spread.
BUY 138/140 Bull Call Spread @0.94
BUY 140/138 Bear Put Spread @1.06
(Click on image to enlarge)
Now, why isn't there a profit? and how can a profit be obtained out of something like this?
The reason there is no possible profit is that the combined cost of the spreads 1.06 and 0.94 = 2.00 equals the width of the spread, 140-138 = 2.00 points. In fact if the pricing of options were always perfect this would always be the case: the sum of contrary spreads would equal the width of the spread.
However, sometimes this is not the case. If the combined cost of the opposite spreads is less than 2.00, on spreads like these of 2.00 range, then there is an arbitrage opportunity! Where risk free money can be made.
Let's say you could buy the 138/140 Bull Call Spread for 0.94 and the 140/138 Bear Put spread for 1.01 instead of the 1.06 it cost on March 9. In that case you would be entering the 2 point wide Box Spread for a total debit of only 1.95 and that results in a guaranteed profit of 0.05, or $5 per contract played.
BUY 138/140 Bull Call Spread @0.94
BUY 140/138 Bear Put Spread @1.01
(Click on image to enlarge)
There is now a guaranteed profit of $5 throughout the whole spectrum of possible SPY prices. The position doesn't need to be closed, you just open it with the guaranteed profit and let it get to expiration.
Exploiting this price inefficiency in reality is difficult, first you need an options friendly broker with very low commissions, as the arbitrage opportunity won't offer more than a few dollars per contract. And second, and this is the main factor, there are many computerized algorithms scanning for arbitrage opportunities like this one every second. If the price inefficiency shows up, algorithms immediately exploit it, which makes the pricing schema adjust itself to normal after a few seconds. This makes the window of opportunity very small for this type of arbitrage to be manually exploited by people.
How can you still benefit from the Box Spread?
Maybe you can't really exploit the Box Spread for opening risk free positions, due to the two factors mentioned above. But knowing the principle that make it work, you can apply that principle in other situations. You can for example lock in profits in existing positions where it is hard to exit due to liquidity issues.
The principle is simple:
The combined cost of two opposite spreads is usually equal to the width of the spreads. If this combined cost is less than the width of the spreads, there is an opportunity to lock in profits.
Let's analyze the first example where I purchase a 138/140 March Bull Call Spread for 0.94. The opposite 140/138 Bear Put Spread is worth 1.06, but I don't purchase that one. I only enter the 138/140 Bull Call spread betting that the market is going up.
BUY 138/140 Bull Call Spread @0.94
A few days later the market has moved up (in my favor) and the 138/140 Bull Call Spread is now worth 1.20. Obviously at this point, the 140/138 Bear Put spread must be trading at 0.80. If at this point I purchase the 140/138 Bear Put spread for 0.80, I would be locking the box with a guaranteed profit.
BUY 140/138 Bear Put Spread @0.80
I have invested 0.94 + 0.80 = 1.74 in a Box Spread that is 2.00 point wide, therefore I have a difference of 0.26 in my favor. The trade will now return $26 per contract at expiration and it is risk free, and there is no need to close anything, just let the whole box expire and save the commissions. There is no way to lose in this position. There is a 0.26 guaranteed profit.
Instead of creating the Box Spread, the trader could have simply sold his Bull Call Spread, which he bought at 0.94 and was trading at 1.20, and the trader would have obtained the same 0.26 profit per contract. That is true, however closing the original position becomes hard in some cases due to liquidity issues. Instruments like SPX, RUT, might be very difficult to close at times due to this reason. But, if you detect that there is more volume in the strike prices of the opposite spread or more open interest, you can decide to create the Box Spread, your fill will be easier and the Box Spread will have the same profit locking effect as if you had closed your original position.
Related Articles:
How to lock in profits on an options trade and stay in the position
Locking profits on a Vertical Spread
The Three Legged Box explained
Go to the bottom of this page in order to see the Legal Stuff