A box spread is a neutral and low-risk options strategy that combines a long call spread and a long put spread on the same underlying asset. This long box includes the simultaneous buying and selling of calls. It puts with the same expiry but differing strike prices to lock in a near risk-free profit when the options are incorrectly priced concerning the underlying security. It’s like two vertical spreads with the same strikes and expiration dates.
How It Works
The construction of a box spread requires an investor to purchase a bull call spread and sell a spread for the same underlying security with matching expiration dates and strike prices. No trading combination consists of purchasing a call option with a lower strike before selling one with a higher strike for the same underlying asset. These two legs in the trade are done either for a net credit or net debit.
Usage and Consideration
Box spreads are typically used for arbitrage purposes and transactions aimed at capitalizing on market price irregularities. They are also used to synthetically borrow or lend for cash management purposes. The profit made is generally restricted to the difference between the strike prices, which makes the strike price selection quite critical. Traders must ascertain whether the profit earned adequately covers transaction fees.
Even though box spreads are made on arbitrage and thus considered riskless, they expose the trader to some risks, such as execution and interest rate risks. Execution risk revolves around the trader’s inability to execute all four legs of the strategy at the desired price levels. Interest rate risk implies that changes in the interest rate may affect the value of the option contracts.