A box spread, also known as a long box, is an option strategy that combines buying a bull call spread with a bear put spread, with both vertical spreads having the same strike prices and expiration dates.
The long box is used when the spreads are underpriced in relation to their expiration values. By reading this article, an investor will gain a basic understanding of this complex option trading strategy.
The box spread is constructed by buying one “in-the-money” call, selling one “out-of-the-money” call, buying one “in-the-money” put, and selling one “out-of-the-money” put. Because four options are included in this strategy, the cost of executing this strategy is very high.
By combing a bull call spread and a bear put spread, it does not matter where the underlying security’s price expires. The potential profit is always going to be the difference between the two strike prices minus the cost of the options.
Example
Assume stock ABC is trading at $100.
First, an investor buys an “in-the-money” call option with a strike price of $97 for $5 per share. Secondly, he buys an “in-the-money” put option with a strike price of $102 for $5 per share. Thirdly, he sells an “out-of-the-money” call option with a strike price of $102 for $3 per share. Lastly, he sells an “out-of-the-money” put option with a strike price of $97 for $3 per share. All four options have the same expiration date in a month.
From these transactions, the investor faces a cost of $4 per share (5 + 5 – 3 – 3 = 4).
If ABC closes at $100 in a month, then the call and put options that were “in-the-money” would be exercised. The other two options would expire as worthless. From the call option, the investor would make $3 per share. From the put option, the investor would make $2 per share. After accounting for the cost of entering this strategy, the investor walks away with a profit of $1 per share (5 – 4 = 1).
If ABC closes at $110 in a month, then both call options would be exercised. Both put options would expire worthless. The investor will make a profit of $13 from the call option that he bought. He will lose $8 from the call option that he sold. From these two options he makes a profit of $5 per share. After accounting for the cost of entering this strategy, the investor walks away with a profit of $1 per share.
If ABC closes at $90 in a month, then both put options would be exercised. Both call options would expire worthless. The investor will make a profit of $12 from the put option that he bought. He will lose $7 from the put option that he sold. From these two options he makes a profit of $5 per share. After accounting for the cost of entering this strategy, the investor walks away with a profit of $1 per share.
From these scenarios, an investor can see that whether the stock’s price rises or falls, the investor will profit as long as the difference between the strike prices is greater than the cost to enter the trade. Since this strategy deals with four options contracts, the cost to enter the trade is very high.
Investors who have a high capital should use this advanced option trading strategy to generate profits.
