What if you could shop around for interest rates on an investment until you found one that you like?
Box spreads allow you to do this. Well, sort of.
They allow you to synthetically borrow or lend money and have implied interest rates. Profit is realized when the positions are closed. We’ll get into the details later… for now, know that box spreads are a unique, advanced options play that inherently feature lower risk, and are relatively easy to set up and execute.
Here we’ll give you all the tools you need to take advantage of this strategy.
Ready? Let’s jump into those details.
What you’ll learn
What Exactly is a Box Spread?
A box spread is a complex options strategy that is built from two spreads, one bull call spread and one bear put spread. These two spreads are known as vertical spreads in options trading, and contain two options within each. These two spreads will have the same strike prices and expiration dates.
The key to this strategy’s effectiveness is finding spreads that are relatively underpriced in relation to their expiration dates.
More often than not, an investment strategy is employed when an investor feels bullish or bearish, but this is a delta neutral strategy, meaning you employ the play when you feel neither bullish nor bearish.
One really great quality of these spreads is their inherent, almost risk-free nature. This is because any losses taken on one side are balanced by the gains on the other side. This is the same concept as a straddle, and how that play is balanced.
Understanding How Box Spreads Work
Alright, so now we understand the basic framework of a box spread, but how do they work when it comes to capturing profit?
Box spreads realize their max profit (at expiration) when the bullish spread’s underlying price closes at the higher strike price, and when the bear spread’s underlying price closes at the lower strike price.
Let’s look at that further by understanding the construction process.
The Construction Process
While it may seem like there are a lot of moving parts with a box spread, it becomes a little more simple when you break it down into its pieces. All it takes to set up a box spread is, purchasing an in-the-money call and put, and selling (or shorting/ writing) an out-of-the-money call and put.
The key here is to make sure that you do not pay more for the setup of the box than the difference between the strike prices at expiration. To calculate max profit, first find the difference in the strike prices, then subtract the cost of the trades from that. Otherwise (if it costs more to set up than the difference in strikes) a short spread might be a good alternative, as the long, or box spread, would not profit.
To use a short box, just switch the ITM and OTM calls you buy, so you would sell the ITM options and buy the OTM options.
Value of Box at Expiration = high strike price – low strike price
Max Profit = (high strike price – low strike price) – (total premium paid + commissions paid)
Max Loss = total premium paid + commissions paid
An Example of a Box Spread
Alright, let’s say an investor is feeling neutral towards the short-term movement of the utilities sector, so they decide to set up a box spread with XLU (Utilities Select Sector SPDR Fund). Its current trade price, as of August 12, 2022, is $75.00.
The investor would buy an ITM call and put:
70 call @ $7.80
80 put @ $3.05
And also sell an OTM call and put:
80 call @ $0.47
70 put @ $0.12
So your total cost would equal the sum of the difference between the calls and puts:
(ITM Call – OTM Call) + (ITM Put – OTM Put)
Calls: 7.80 – 0.47 = 7.33
Puts: 3.05 – 0.12 = 2.93
7.33 + 2.93 = $10.26
So the total cost of the box would be $10.26 per share, or $1,026 total. Now, the investor just needs to make sure that the value of the difference between the strike prices at expiration does not equal the premium per share of the box (plus any commissions paid).
Difference in strikes, aka the expiration value = $10 per share, or $1,000 total
Total cost of spread = $1,026
So in this example, it would not be advantageous for the investor to set up a box spread with XLU because it would cost them more than the expiration value of the spread.
This is a perfect example of why this play is the most effective when the value of the contracts is low relative to the expiration. If it was in this case, the play could have easily profited so long as the contracts that were written weren’t exercised, and the underlying price stayed fairly neutral.
Iron Condor vs. Box Spread – Differences Compared
It’s worth looking at the similarities and differences to an iron condor and a box spread because they have a similar setup, and in comparing the two, you’ll know which one to use when the time comes.
Firstly, both strategies involve four options, consisting of two calls and two puts. The set up of the two spreads is different, though. See images below. With box spreads you have two spreads (bull call and bear put) with matching strike prices. With iron condors you have two spreads that have different strike prices. With the expirations dates, they’re kept the same for both strategies.
One way to think about this is to compare and contrast a straddle and a strangle. Straddles and strangles involve two options, one call and one put. Straddles have the same strike price, and strangles have different strike prices. Because of this, they can be used at different times to capture profit in different ways.
Both iron condors and box spreads, however, are neutral strategies. So you could in fact use these two strategies in similar situations. Because while strangles and straddles profit from the movement of the underlying price, with iron condors and box spreads, profit is realized when the underlying price stays close to the same as when you opened the positions.
The strategy is typically used when the investor believes that the price of the underlying asset is likely to stay within a certain range.
This strategy is designed to take advantage of an expected rise in the price of the underlying security.
As you can see, visually, the difference between the setups is quite obvious.
Advantages and Disadvantages
Let’s talk about this strategy’s risk. This is not a “risk-free” strategy, as many claim. Though it is a relatively safe strategy.
There are indeed risks to using box spreads. factors like changes in implied interest rates. The scarier risk, though, is the risk of the contracts being exercised (with US options) as this could lead to some serious losses.
One trader that was using Robinhood suffered a tremendous loss after his short box play went awry after making a claim that the play cannot fail. He took a $57,000 loss on a $5,000 investment. We don’t mean to scare you, as this play is generally pretty safe, and the person who did this was not informed, and a little cocky. Just take a couple basic precautions before jumping into it.
Lastly, box spreads allow you the chance to profit if an underlying price is neutral. Where the normal method goes, “buy low, sell high”, boxes open a new door to a different possibility. Identifying the right timing to enter and exit a box spread can be very challenging. This is one of the many benefits of subscribing to a derivatives trading alert service where a team of seasoned traders provide alerts regarding potentially profitable setups and trades for the receivers of their signals to look into.
When is a Good Time to Use Box Spread Strategy?
There are two main criteria that should contribute to your decision to use a box spread. First, a box spread is a neutral strategy as we touched on above. So this strategy is great if you are feeling neutral towards the short term direction in the underlying price.
Second, and this is arguably the most important to pay attention to, is to use the strategy if you spot spreads that are relatively underpriced relative to their expiration date. This is crucial because this is the entire point of the strategy. We saw in the example above how to calculate max profit by comparing the difference in strike prices to the premiums paid (plus any commissions paid).
If you would end up paying more to build the strategy than the actual box value at expiration (difference between high and low strike price), obviously this would not be a good time to use a long box spread, so a short box may be appropriate.
Now, this is the basic criteria of when to use a box spread, so let’s get into the who and why.
Box spreads, most of the time, are treated like loans, whether you’re borrowing or lending. So investors that are interested in borrowing can obviously do that at a bank, but as an alternative, they could use boxes if they want a better rate.
Using Box Spreads in Futures Trading
One aspect of box spread we have not directly touched on yet, although you may have already picked this up, is that it is an arbitrage strategy. Meaning it attempts to capture profit from the short term fluctuations in related assets. This is something commonly done in the futures market.
So box spreads can be used in futures trading also, which opens some new doors for investors.
Conclusion
Box spreads are a unique, low risk options strategy, giving you the ability to synthetically borrow or lend money, and earn a profit from their implied interest rates. They are similar to an iron condor, but differ in how they profit, as the strike prices of the spreads in boxes are the same, and iron condors are different.
This type of spread is a good strategy for those that do not want to take on very much risk, as the strategy protects itself due to the design of its setup, similar to a straddle. It is also a good strategy if you were feeling neutral towards the direction of an underlying price.
Finally, make sure to be aware of some of the risks associated with boxes, as they are not risk-free as some claim. They could be exercised/ assigned with US options, for example.
At this point, you’re well on your way to learning how to trade options. Keep reading and learning – there’s a lot more to discover!
The Box Spread Strategy: FAQs
When is it Appropriate to Use a Box Strategy?
It is appropriate to use a box strategy when an investor feels naturally towards an asset’s price movement, and has the capital to set up the play.
Is the Box Spread Strategy Risk Free?
While there aren’t necessarily ‘direct’ risks with box spreads, there are some hidden risks investors need to be aware of, such as changing interest rates, exercising the contract(s) too early, which could seriously put you in the hole, especially with short box spreads.
What is a Short Box Spread?
A short box spread is the inverse of a long box spread. Where with a long spread you purchase ITM calls and puts, and sell OTM calls and puts, a short spread would require the investor to sell ITM calls and puts, and buy OTM calls and puts.
What is the Point of a Box Spread?
The point of a box spread is for investors to capture profit when they are delta neutral, while at the same time minimizing risk.
How Do You Execute a Box Spread?
A box spread is executed by purchasing two options, and selling another two. In order for it to be considered a box spread, though, the options you purchase need to be an ITM call and put, and the options you sell need to be an OTM call and put.
