A box spread is an options trading strategy that uses a bull call spread and a bear put spread with the same strike prices to profit from arbitrage.
When the available options for the box spread are priced favorably, a day trader can achieve a risk-free profit from the use of the box spread options trading strategy.
Spreads
The box spread options trading strategy is based on the simpler options trading strategy of spreads.
A spread in options trading is a strategy that uses the sale of a further from the money option contract to offset the price of the purchase of a nearer to the money option contract. This reduces the risk involved in the purchase of an option contract, but also limits the potential profit from the position.
For example, suppose that the shares of company A are currently trading at $45 per share. A day trader believes that the price of the shares will rise to $50 per share by the end of the month, but will not exceed $55 per share.
Therefore, the day trader purchases a call option for 1 month with a $50 strike price for $2 and sells a call option with a 1 month expiry and $55 strike price for $1.
Spreads can be bullish or bearish, and can use either call options or put options.
Box Spread
A box spread is merely the combination of a bull call spread with a bear put spread that relies on favorable option pricing to provide risk-free arbitrage profits.
The value of the box spread occurs as a result of the use of 2 off-setting spreads. This value must simply be greater than the total cost of the premiums involved.
For example, suppose that the shares of company A are currently worth $45 per share. The day trader buys a call option with a $40 strike price and sells a call option with a 50$ strike price, while also buying a put option with a $50 strike price and selling a put option with a $40 strike price.
The ‘spread’ in this particular example is the $10 between the $50 and $40 strike prices. No matter where the price moves, the intrinsic value of the position at expiration will be $10 for each option contract that expires with intrinsic value.
Therefore, as long as the total cost of the premiums paid to open the position is lower than the total profit from exercising all the options with intrinsic value at expiration, then the day trader has achieved a risk-free arbitrage profit from the box spread position.
Box Spreads and Trading
Because options are largely priced based on their historical price performance, box spreads and other similar arbitrage opportunities are a not uncommon result.
While box spread opportunities are difficult to perceive using the naked eye and mental calculation, they can be identified easily enough using rough signals followed by automated price analysis.
Many day traders use advanced software to identify box spreads and other similar trades.
Final Thoughts
The box spread is an emblematic option trading strategy that demonstrates how the pricing of options can often lead to risk-free arbitrage opportunities for skilled day traders.
However, these highly technical trades often require the use of advanced trading software to identify and execute.