Option Investor
Educational Article

Reducing Risk With the Box Spread

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There are a variety of strategies available to options traders who want to reduce risk. Some of the most popular techniques in this category involve the use of spreads or combination positions. In last weeks segment, we examined one of the subtle differences in the option pricing characteristics of vertical spreads. Today well look at a position the "box spread," which allows traders to determine what a spread should (theoretically) be worth in the open market.

Unless you are a floor broker or specialist, you have probably never heard about this technique. The reason is, a box spread is not is retail trading strategy, rather it is a tool to help evaluate the fair value of options at different strike prices. Despite the fact that it is rarely used by retail market participants, the box spread can be very helpful for traders who enter and exit spreads with net-debit and net-credit orders. Indeed, those who understand the fundamental concepts of the box can use this knowledge to determine if a spread order is likely to be executed at a specific price.

The Box Spread

The box spread is a relatively uncomplicated position. It consists of a bullish spread and a bearish spread with the same expiration date and characteristics. From an individual options viewpoint, a box spread involves a long call and a short put at one strike price and a short call and a long put at another strike price, all of which are in the same contract month and the same underlying issue. Here's an example:

XYZ stock = $100

Buy APR-$100 call
Sell APR-$105 call

-and-

Buy APR-$105 put
Sell APR-$100 put

This trade will result in two debit spreads, a bull-call and bear-put. Regardless of the price of the stock, at expiration the position will always be worth the distance between the spread strikes in this case, $5.00. It doesn't matter how high or low the stock moves, one (or both) of the spreads will be in-the-money and the sum total will be equal to the difference in the long and short strikes of the spread. Consider these outcomes (for the stock price) at expiration:

As you can see, the combination of a long $100 call plus a short $100 put, and a long $105 put plus a short $100 call, always results in a net credit of $5.00. In addition, the geometric nature of the positions (four sides) becomes more apparent, thus offering a basis for the term "box" spread.
 

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