A short box spread is a multi-leg, risk-defined, neutral options strategy with limited profit potential. Short box spreads look to take advantage of underpriced options and create a risk-free arbitrage trade.
The short box spread consists of selling a bull put credit spread and selling a bear call credit spread centered at the underlying stock price. The two spreads have the same strike prices and expiration dates, which creates a “box” around the stock price.
Short Box Spread Outlook
Short box spreads are used as a tool to generate a potentially risk-free profit. The strategy is neutral and not dependent on any directional movement from the underlying asset. A short box spread attempts to exploit options mispricing and capitalize on overpriced spreads in the market. Box spreads rely on inefficiencies in option premium pricing. For example, for a short box spread to be profitable, a $10 wide spread between options would need to be sold for more than $10.
Short box spreads have become increasingly difficult to execute with the computerization of financial markets. Investors also need to be aware of the risk of assignment before expiration. If an assignment occurs before expiration, the cost to hold the short position may exceed the available margin in the account, which would force the investor to exit the position immediately. This forced closure due to assignment could compromise the pricing to exit the position and result in a loss. For this reason, box spreads are not truly “risk-free.” One way to avoid this potential issue is to use short box spreads on cash-settled instruments like index funds.
Short Box Spread Setup
A short box spread has four components, and consists of selling a bull put spread and selling a bear call spread. The short spreads will have the same strike prices and expiration dates. The underlying stock will be centered inside the “box.”
For example, if a stock is trading at $50, a $45 call is sold, and a $55 call is purchased. Simultaneously, a $55 put is sold, and a $45 put is purchased. Thus, a $10 wide short box spread is created around the stock. If pricing is efficient, the box spread would be sold and bought for $10. However, investors selling a short box spread look to exploit an inefficiency in the bid-ask spread. If the short box spread can be sold for $10.50, a risk-free profit of $.50 is anticipated, because the spread should trade for $10 at expiration, regardless of where the underlying stock price is trading.
Even if optimal pricing is achieved when the trade is entered, the risk of early assignment still exists. This may force the trade to be closed at less than ideal pricing.
Short Box Spread Payoff Diagram
The payoff diagram for a short box spread is simply two short credit spreads with the stock price somewhere between the long and short strike prices. The strategy is unaffected by the movement of the stock price, as the spreads will cancel out when closed at expiration. What is more important with a short box spread is the price to enter the position relative to the width of the legs in the two credit spreads. For the strategy to be profitable, the bull call spread and bear put spread must be sold for a price more than the width of the spreads when the position is opened.
For example, if a stock is trading at $50, a $45 call is sold, and a $55 call is purchased. Simultaneously, a $55 put is sold, and a $45 put is purchased. Thus, a $10 wide short box spread is created around the stock. If pricing is efficient, the box spread would be sold and bought for $10. If the short box spread can be sold for $10.50, a risk-free profit of $.50 is anticipated, because the spread should trade for $10 at expiration, regardless of where the underlying stock price is trading.
Entering a Short Box Spread
A short box spread is made up of a bull put credit spread and a bear call credit spread. The two short spreads have the same strike prices and expiration dates. The underlying stock price will be trading somewhere between the spreads. Sell-to-open (STO) a short in-the-money call below the stock price and buy-to-open (BTO) a long out-of-the-money call above the stock price. At the same time, sell-to-open (STO) a short in-the-money put above the stock price and buy-to-open (BTO) a long out-of-the-money put below the stock price.
Because the strategy consists of two credit spreads, it will collect money at entry. The goal is to sell the short box spread for more money than the width of the spreads. To ensure that the pricing will be stable at the time of entry, the four legs of a short box spread must be sold simultaneously. However, this is very difficult to execute at arbitrage with the current efficiency of markets.
Exiting a Short Box Spread
A short box spread is closed by purchasing the bull put spread and bear call spread simultaneously. Ideally, the two positions are bought for the maximum amount of the spread. Because the two spreads are purchased with the same strike prices and expiration, the underlying stock price does not affect the ability to exit the position for the full amount of the spread width.
Time Decay Impact on a Short Box Spread
Time decay, or theta, has no direct impact on the profitability of the short box spread strategy. Because the position looks to take advantage of arbitrage and has opposing credit spreads, it does not capitalize on time decay.
Implied Volatility Impact on a Short Box Spread
Implied volatility has no direct impact on the profitability of the short box spread strategy. Because the position looks to take advantage of arbitrage and has opposing credit spreads, it does not capitalize on an increase or decrease in implied volatility. However, volatility may affect the pricing inefficiencies when the short box spread is entered and/or assist with potentially buying back the position for less premium than the width of the spread. This is rare and not to be expected. Future volatility, or vega, is uncertain and unpredictable.
Adjusting a Short Box Spread
Short box spreads are not typically adjusted because the strategy’s profit potential is based upon pricing inefficiencies at trade entry. The goal of a short box spread is to sell two credit spreads for more money than the width of the spreads. If that is accomplished when the position is opened, it will be successful because the four options will be bought back at expiration for less money than they were sold.
However, investors need to be aware of the risk of assignment prior to expiration. If assigned, the margin to fulfill a short sell assignment obligation in the underlying stock position may exceed the account’s available funds. The investor would be forced to exit the position prematurely, possibly for a loss.
Rolling a Short Box Spread
Typically, there is no advantageous way to roll out a short box spread. Because the strategy attempts to capitalize on brief periods of market inefficiency, the price to enter the position will be the best available situation. The strategy aims to exit the options at the full value of the spread width between the credit spreads. If an investor was able to enter the position for more than the width of the spread, there is no way to improve the strategy via a roll.
Hedging a Short Box Spread
Short box spreads are not typically hedged. The goal of a short box spread is to exploit an arbitrage situation based on the mispricing of option spreads. If a short box spread is sold for more than the spreads’ width, it will be profitable at exit, barring an early assignment. If the strategy costs less than the amount of the spreads, it does not make sense to enter into a short box spread.
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