Box spreads and arbitrage strategies are often synonymous with one another and referenced interchangeably in the options trading community. And after all, who doesn’t want a risk-free way to earn money, right? But like all things that seem too good to be true, box spreads carry some serious risks if you’re not careful in how you set them up. Today’s show focuses exclusively on box spread basics for options traders.

What is a Box Spread?

• A box spread is where you buy and sell all of the contracts in a box.
• Essentially, you are creating a box of contracts around the market using four contracts: two on each side of the options pricing table.

Buying a Box Spread

• If the S&P is trading at 281, you can create a box spread by combining two strategies and using the same strikes on either side.
• The first strategy is a bull call spread, a debit spread where you’re buying a spread on the call side of the pricing table.
• For example, you would buy the 275 call and sell the 285 call. That would give you a $10 wide bull call spread on the call side at a cost of $6.28.
• On the put side, you will buy a bear put spread, a debit put spread using the same strikes just in the opposite buy and sell order.
• For example, you would buy the 285 put and sell the 275 put, creating the box spread.
• The spread width for this box spread is $10, which will be the value of the spread at expiration. The goal is to buy this box spread at a premium less than the width of the spread.

Selling a Box Spread

• When selling a box spread, you want to sell it for potentially a higher value than the width of the spread–if you can get that order filled.

Risks

Pricing Differential:

• The only real way to guarantee that it’s going to be risk-free or arbitrage is to fill all of the legs at the same time.
• However, this is probably not going to be possible, because market makers, institutions, and computers are going to collapse those spreads so that there’s no easy money to be had.

Assignment:

• You will never be able to fill a box spread in its entirety to lock in a profit — market makers just won’t let it happen.
• Markets have become much more efficient, and the arbitrage opportunity is near zero.
• Even if you get both the put sides and call sides filled independently at your desired price point (which can only really happen by gaming the wider bid/ask spreads on deeper ITM spreads), the assignment risk is astronomical.
• If you can’t handle that assignment risk, then it will force you to sell your position at a significant loss in order to get the contracts filled.
• To avoid assignment risk, perhaps the next natural progression would be to sell box spreads in securities with cash settlement like SPX.

Broker Considerations

• When entering a box spread, make sure to call your broker and discuss what’s going to happen during exercise at expiration.
• If the broker decides to close one side early due to arbitrary risk parameters, or one side gets exercised early by the counter-party (assuming American style), you will be in deep trouble if you don’t have the cash collateral to cover the trade.

Box Spreads as Financial Vehicles

• The intent of a box spread, for many traders, isn’t only for arbitrage.
• At the retail level, people are looking for a risk-less way to make money.
• At the institutional level, market makers with massive amounts of capital can use them as a vehicle to borrow money on index options.
• Box spreads allow market participants to create a loan structure similar to a Treasury bill. T-bills are “discount” instruments that are purchased at a value less than the stated face value. Upon maturity, Treasury bills call for the return of the stated face value.

Case Study: 1ronyman

• He did a very large, very aggressive box spread in UVXY, a highly leveraged ETF.
• Bought 500 contracts of the $15 calls at $51.65.
• He then sold 500 contracts at the 10 calls of 56.25.
• Again, he bought 500 calls at the 15 strike, then sold 500 calls at a 10 strike.
• The total credit that he collected on the call spread side was $4.60.
• On the put side, he just did the inverse, buying 500 of the 10 strike puts for $2.88 and then he sold 500 of the 15 strike puts for $4.03.
• On the put side, the total credit that he collected then was $1.15.
• The total credit collected for the box spread was $5.75.
• If everything worked out, he would have earned a massive gain on it — a risk-free profit of $37,500.
• His account contained $5,000 and was allowed to enter a position that should have had an account carrying $200,000 to $300,000 worth of margin to cover this position.
• However, if you get assigned on your short call option at $10, since you don’t have the capital to cover it, you have to go out and exercise your $15 strike call options to get the underlying to settle the trade.
• This creates a $5 loss every single time just through the process of assignment and exercise. Since you sold the call spread for a credit of $4.60, this means that no matter what happens, you still lose 40 cents or $40 per contract spread when assigned.
• If you lose $40 per spread times the 500 spreads that you traded, that’s a $20,000 loss if you go through assignment.
• Therefore, the assignment risk is more than the actual account value of $5,000.
• On the put spread side, again, when assigned, you create a scenario where you lose $5 every time.
• When you factor in the $1.15 credit, the net loss on the position is $3.85 if assigned.
• Every time that you have to deal with an assignment, you potentially put yourself in a position where you could lose $3.85 for every single contract.
• This created a risk of $192,500 just on the put spread side.
• Therefore, the assignment risk early in the expiration process is very, very aggressive.

Option Trader Q&A w/ Greg

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Greg:

I’ve been wondering for some time about when you have an ETF based on an index like SPY versus the SPX, the SPX I know or I understand is an accumulation of everything that’s involved in the S&P 500 and that the price at any given moment is nothing but a result of all of that. SPY though, I wonder, is that the exact same? Does that work in the exact same way or is the price varied by the supply and demand upon the SPY itself as a separate issue?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.