Short box spreads are a way to potentially achieve risk-free profits by capitalizing on price inefficiencies in options markets. This short box option strategy involves opening two selling a bull put spread and a bear call spread. Explore how this method offers intriguing opportunities with calculated risks and rewards.
Key takeaways
- The short box spread options strategy is a potentially risk-free arbitrage method used to exploit price inefficiencies in options markets.
- To open a short box spread, you will sell a bull put spread and a bear call spread at the same strike prices and expirations.
- Shorting ITM options may result in early assignment, leading to leveraged positions due to receiving underlying stocks, hence incurring interest on loans if the options are exercised.
What Is the Short Box Spread?
The short box spread is an options trading strategy aiming to generate risk-free profits by exploiting mispricings. It involves selling both a bull put credit spread and a bear call credit spread on the same underlying stock. Both spreads share identical strike prices and expiration dates, forming a “box” around the stock price.
The typical profit and loss (P&L) profile of a short box spread will look like this (focus on the white line):
As you can see, the short box option strategy is neutral (notice how the white lines remains horizontal regardless of the underlying price), meaning it doesn’t depend on any directional movement of the asset. Instead, it capitalizes on overpriced spreads in the market, which arise from inefficiencies in option premium pricing. To give you a clearer idea, a $15 wide spread must be sold for more than $15 to be profitable.
However, executing short box spreads has become tougher with the rise of computerized financial markets. These systems have decreased the number of pricing inefficiencies, so your arbitrage operation will be harder to find and execute.
Additionally, there’s the risk of assignment before expiration. If this happens, maintaining the short position might require more margin than available, forcing an immediate exit.
To mitigate these risks, consider:
- Using short box spreads on cash-settled instruments like index funds.
- Use European options that can only be assigned at expiration.
- Monitoring the position closely to manage potential assignments.
These strategies can help in avoiding forced closure, which could affect pricing and lead to losses. Despite the potential for risk-free profits, these spreads come with their own set of challenges, making them not entirely risk-free. If you understand the structure and potential pitfalls, you can use short box spreads more effectively.
An Example of the Short Box Spread Option Strategy
Let’s look at a short box spread example to clarify the theoretical aspects mentioned above. Suppose NVDA is now trading at $143.71. In this example, we’ll create a short box spread, which involves selling a bull put spread and a bear call spread (just like those you may find on our market screener for options) simultaneously.
To give you an anticipation, this is the P&L of the short box strategy we are going to see:
The steps below will help you understand how this strategy is constructed and managed.
Step 1: Structure the Short Box Spread
First of all, begin building the four sides of the “box” by doing this:
- Sell 1 ITM call with a strike price of $140: Hypothetical premium received: $6.50, resulting in a $650 credit per contract.
- Buy 1 OTM call with a strike price of $150: Hypothetical premium paid: $2.10, resulting in a $210 debit per contract.
- Sell 1 ITM put with a strike price of $150: Hypothetical premium received: $7.80, resulting in a $780 credit per contract.
- Buy 1 OTM put with a strike price of $140: Hypothetical premium paid: $1.80, resulting in a $180 debit per contract.
Step 2: Calculate the Net Premium Received
The four sides above actually constitute a bear call spread and a bull put spread, which are both credit strategies.
The bear call spread involves selling a $140 call and buying a $150 call, resulting in a $440 credit after subtracting a $210 debit from a $650 credit. Meanwhile, the bull put spread consists of selling a $150 put and buying a $140 put, yielding a $600 credit by subtracting a $180 debit from a $780 credit.
Combining both strategies, the total net premium received amounts to a $1,040 total credit. This is the amount of cash you receive once you open the strategies, keep it in mind.
Step 3: Expiration Value of the Box Spread
The expiration value of the box spread is calculated by finding the difference between the strike prices, which is $150 – $140, resulting in $10. Since each options contract controls 100 shares, you then multiply the $10 by 100 to determine that the expiration value of the box spread at expiration is $1,000.
The total credit received was $1,040, while the expiration value of the box spread was $1,000. This results in a risk-free profit calculated as $1,040 (credit received) minus $1,000 (final payout), leading to a $40 profit.
Therefore, here is what you have:
- Since you received $1,040 in credit for selling the short box spread, and the box will expire with a value of $1,000, you are guaranteed a $40 risk-free profit at expiration.
- This profit is locked in because you sold the box spread for more than its expiration value.
Do Time Decay and Implied Volatility Affect Your Short Box Spread Position?
Moving beyond the practical example mentioned above, there are a few key considerations before opening a short box spread position:
- Time Decay: Often referred to as theta, time decay does not directly impact the profitability of a short box spread. This approach capitalizes on arbitrage through opposing credit spreads, so it remains unaffected by the passage of time.
- Implied Volatility: Although implied volatility doesn’t directly alter the profitability of the short box option strategy, it can influence pricing inefficiencies when setting up the trade. While changes in volatility might occasionally help in buying back the position for less than the spread’s width, this is relatively rare. Future volatility, termed vega, remains uncertain and can be unpredictable.
When it comes to trading a short box strategy, the “elephant in the room” is the assignment risk. Let us tell you more about it in the next section.
How Does Assignment Work with the Short Box Strategy?
The main thing you should know before entering a short box spread is that assignment can occur if you’re shorting in-the-money (ITM) options. This is especially true for American options, common in stocks and ETFs, which can be exercised at any time. If an option is exercised, you will receive the stocks. While you’re hedged against asset movement, you become highly leveraged and may incur interest on the loan for holding the stocks.
Here’s a breakdown of the assignment process:
- Assignment Process: In a short box option strategy, if your short options are ITM, you risk early exercise. Typically, a deep ITM (DITM) put option will trigger assignment, while a DITM call option, especially if a dividend is due, might also be exercised.
- Effects of Exercise: When your options are exercised, you’re obligated to fulfill the contract terms, which means purchasing or delivering the underlying stock. This doesn’t typically lead to a loss from price changes but can tie up capital and increase leverage.
- Risks and Obligations: The main risk is the financial burden of maintaining stock positions, which might exceed your available margin. If margin requirements aren’t met, you could be forced to close positions, possibly at a disadvantageous price.
Understanding these elements is essential for managing a short box spread effectively. Being prepared for the potential financial impact and having a strategy to address unexpected assignments can reduce risks associated with this options trading strategy.
Does It Make Sense to Adjust or Roll a Short Box?
Before leaving you, we want to address a common question: does it make sense to adjust or roll a short box spread? The short answer is that adjustments to a short box spread are generally not recommended. The table below summarizes the main arguments against adjusting or rolling a short box strategy:
Adjusting a Short Box Spread
The truth is that, in practice, short box spread adjustments are really rare. Since the short box option strategy relies on mismatches in the market at the outset, adjustments aren’t typically needed. The position is designed to profit from these temporary inefficiencies.
Rolling a Short Box Spread
Generally, there is no beneficial method to roll a short box spread. This strategy is not about extending positions but about capturing a market inefficiency at a moment in time. Rolling doesn’t typically add value since the strategy seeks to close options at the full value of the spread’s width between credit spreads.
If you’re curious about a similar yet distinct strategy, check out our guide on the box spread to explore its mechanics and use cases.
