Box Spread (Long Box) The box spread, or long box, is a common arbitrage strategy that involves buying a bull call spread together with the corresponding bear put spread, with both vertical spreads having the same strike prices and expiration dates. Jun 27, 2013 Short Box and Long Box are great arbitrage trades with zero loss and good profits but you will rarely find this opportunity in any stock or Nifty. In fact any kind of options arbitrage.
What is a Box Spread
A box spread, also known as a long box, is an arbitrage strategy created by combining a bull call spread with a corresponding bear put spread. These vertical spreads must have the same strike prices and expiration dates.
The idea is to use the box when the spreads themselves are underpriced regarding their expiration values. When the trader believes the spreads are overpriced, he or she may employ a short box, which uses the opposite options pairs.
BREAKING DOWN Box Spread
A bullish vertical spread maximizes its profit when the underlying asset closes at the higher strike price at expiration. The bearish vertical spread maximizes its profit if the underlying closes at the lower strike at the contract end. By combining both a bull call spread and a bear put spread, it does not matter where the underlying closes because the payoff is always going to be the difference between the two strike prices. If the cost of the spread, after commissions are less than the difference between the two strike prices, the trade locks in a riskless profit, making it a delta-neutral strategy.
Building a Box Spread
The basic plan is to buy an in-the-money (ITM) call, sell an out-of-the-money (OTM) call, buy an ITM put and sell an OTM put. Put another way, buy an ITM call and put, and then sell an OTM call and put. Because there are four options in this combination, commissions can be a significant factor in its potential profitability.
Example: Intel stock trades for $51.00. Each options contract in the four legs of the box controls 100 shares of stock. The plan is to:
- Buy the 49 call for 3.29 (ITM) for $329 debit per options contract
- Sell the 53 call for 1.23 (OTM) for $123 credit
- Buy the 53 put for 2.69 (ITM) for $269 debit
- Sell the 49 put for 0.97 (OTM) for $97 credit
The total cost of the trade before commissions would be $329 - $123 + $269 - $97 = $378.
The spread between the strike prices is 53 - 49 = 4. Multiply by 100 shares per contract = $400 for the box spread.
In this case, the trade can lock in a profit of $22 before commissions. The commission cost for all four legs of the deal must be less than $22 to make this profitable. That is a razor-thin margin. And this is only when the net cost of the box is less than the expiration value of the spreads, or the difference between the strikes. There will be times when the box costs more than the spread between the strikes so the long box would not work. However, a short box might. This strategy reverses the plan and sells the ITM options and buys the OTM options.
Table of Contents
- What Is a Butterfly Spread?
- Short Call Butterfly Spread
- Short Put Butterfly Spread
- Reverse Iron Butterfly Spread
What Is a Butterfly Spread?
A butterfly spread is an option strategy combining bull and bear spreads, with a fixed risk and capped profit. Butterfly spreads use four option contracts with the same expiration but three different strike prices. A higher strike price, an at-the-money strike price, and a lower strike price. The options with the higher and lower strike prices are the same distance from the at-the-money options. If the at-the-month options have a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60.
Puts or calls can be used for a butterfly spread. Combining the options in various ways will create different types of butterfly spreads, each designed to either profit from volatility or low volatility.
Key Takeaways
- There are multiple butterfly spreads, all using four options.
- All butterfly spreads use three different strike prices.
- The upper and lower strike prices are equal distance from the middle, or at-the-money, strike price.
- Each type of butterfly has a maximum profit and a maximum loss.
Long Call Butterfly Spread
The long butterfly call spread is created by buying one in-the-money call option with a low strike price, writing two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. A net debit is created when entering the trade.
The maximum profit is achieved if the price of the underlying at expiration is the same as the written calls. The max profit is equal to the strike of the written option, less the strike of the lower call, less premiums and commissions paid. The maximum loss is the initial cost of the premiums paid, plus commissions.
Short Call Butterfly Spread
The short butterfly spread is created by selling one in-the-money call option with a lower strike price, buying two at-the-money call options, and selling an out-of-the-money call option at a higher strike price. A net credit is created when entering the position. This position maximizes its profit if the price of the underlying is above or the upper strike or below the lower strike at expiry.
The maximum profit is equal to the initial premium received, less commissions. The maximum loss is the strike price of the bought call minus the lower strike price, less the premiums received.
Long Put Butterfly Spread
The long put butterfly spread is created by buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price. A net debit is created when entering the position. Like the long call butterfly, this position has a maximum profit when the underlying stays at the strike price of the middle options.
The maximum profit is equal to the higher strike price minus the strike of the sold put, less the premium paid. The maximum loss of the trade is limited to the initial premiums and commissions paid.
Short Put Butterfly Spread
The short put butterfly spread is created by writing one out-of-the-money put option with a low strike price, buying two at-the-money puts, and writing an in-the-money put option at a higher strike price. This strategy realizes its maximum profit if the price of the underlying is above the upper strike or below the lower strike price at expiration.
The maximum profit for the strategy is the premiums received. The maximum loss is the higher strike price minus the strike of the bought put, less the premiums received.
Iron Butterfly Spread
The iron butterfly spread is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option, writing an at-the-money call option, and buying an out-of-the-money call option with a higher strike price. The result is a trade with a net credit that's best suited for lower volatility scenarios. The maximum profit occurs if the underlying stays at the middle strike price.
The maximum profit is the premiums received. The maximum loss is strike price of the bought call minus the strike price of the written call, less premiums received.
Reverse Iron Butterfly Spread
The reverse iron butterfly spread is created by writing an out-of-the-money put at a lower strike price, buying an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price. This creates a net debit trade that's best suited for high-volatility scenarios. Maximum profit occurs when the price of the underlying moves above or below the upper or lower strike prices.
The strategy's risk is limited to the premium paid to attain the position. The maximum profit is the strike price of the written call minus the strike of the bought call, less premiums paid.
Example of a Long Call Butterfly Spread
![Box Spread Strategy Nifty Box Spread Strategy Nifty](http://zerodha.com/varsity/wp-content/uploads/2016/01/Image-1_fut-payoff.png)
An investor believes that Verizon stock, currently trading at $60 will not move significantly over the next several months. They choose to implement a long call butterfly spread to potentially profit if the price stays where it is.
An investor writes two call options on Verizon at a strike price of $60, and also buys two additional calls at $55 and $65.
In this scenario, an investor would make the maximum profit if Verizon stock is priced at $60 at expiration. If Verizon is below $55 at expiration, or above $65, the investor would realize their maximum loss, which would be the cost of buying the two wing call options (the higher and lower strike) reduced by the proceeds of selling the two middle strike options.
If the underlying asset is priced between $55 and $65, a loss or profit may occur. The amount of premium paid to enter the position is key. Assume that it costs $2.50 to enter the position. Based on that, if Verizon is priced anywhere below $60 minus $2.50, the position would experience a loss. The same holds true if the underlying asset were priced at $60 plus $2.50 at expiration. In this scenario, the position would profit if the underlying asset is priced anywhere between $57.50 and $62.50 at expiration.
This scenario does not include the cost of commissions, which can add up when trading multiple options.