What Is the Box Spread Trading Strategy?
Box spread trading involves buying and selling options contracts in a way that creates a market-neutral position . Traders buy and sell a combination of call and put options to earn guaranteed profits. But how does it work? And how can you implement a box trading strategy to counter market risks?
We will discuss what box trading strategy is, how it works and its benefits and risks. Read along to know.
What Is Box Spread Trading?
Box spread trading is an options trading strategy that involves buying and selling options to create a market neutral position. This is an arbitrage opportunity where traders simultaneously trade 4 options contracts: 2 calls and 2 puts. These options have the same expiration date but different strike prices. Profits made depend on the difference between strike prices and net premiums paid.
Box spreads are typically used in situations where the market is volatile, and traders are looking for a way to hedge their positions. The ultimate key to this strategy is ensuring that the overall cost of buying options is less than the profits from selling them.
If it is still unclear enough how a box trading strategy works, let us understand this concept with an example below.
How Does the Box Spread Trading Strategy Work?
Box spread trading strategy works by exploiting market inefficiencies in options pricing. Here are the steps to take part in box spread trading:
- Identify an Opportunity: The first step in a box spread trading strategy is to identify an opportunity. This typically involves finding a situation where there is a significant price difference between the options contracts and their underlying asset.
- Buy and Sell Options: The next step is to buy and sell options contracts to create a risk-free position. This typically involves buying and selling four options contracts.
- Calculate Profits: The final step is to calculate profits. If the cost of buying options is less than selling them, it will generate a risk-free profit.
So let us assume that an XYZ share has a current market price of ₹25 per share with a lot size of 100. As stated before, traders simultaneously execute 4 options contracts at the same time which are as follows.
Purchasing options require a buyer to pay a premium to the seller. Hence, let us assume that the premium for call options at ₹20 is ₹5 per share and the premium for call options at ₹30 is ₹1. Similarly, the premium for put options at ₹8 and ₹12 is ₹2 and ₹5 per share respectively.
Remember, you will have to purchase an In-The-Money (ITM) call and put options, whereas, sell Out-of-The-Money (OTM) call and put options. What are ITM and OTM?
When the option’s predetermined price surpasses the prevailing market price and one has to pay a premium, then it is an ITM. In contrast, if the option’s prevailing market price is higher than the strike price, and no intrinsic value is involved, it is said to be an OTM.
1st Trade with 2 Call Options
You purchase call options for ₹20 per share from a seller and sell call options to a buyer for ₹30 per share. Therefore, for purchasing the call option, you will be paying and receiving a premium of ₹5 and ₹ 1 for purchasing and selling call options respectively.
Hence, your overall cost will be (₹5 – ₹1) = ₹4 x (lot size) = ₹400.
2nd Trade with 2 Put Options
In this case, you purchase put options at ₹30 and sell put options at ₹20, paying and receiving ₹2 and ₹4, respectively as premium.
Overall cost incurred will be (₹5 – ₹2) = ₹2 x (lot size) = ₹300.
Concluding all 4 trades, the overall cost will be (₹40 + ₹30) = ₹700.
Now, at the time of contract expiry, the overall value of the box spread will be (₹30 – ₹20) x (lot size) = ₹1,000.
As you can see, the value at expiration is higher than the prevailing market price, as a result, you will profit (₹1,000 – ₹700) = ₹300.
This way you can hedge your portfolio against adverse market movements. However, that does not mean that the strategy does not have flaws. Hence, below are some benefits and risks involved in a box spread trading strategy.
What Are the Benefits of Box Spread Trading?
Box spread trading strategy offers several benefits to traders, including:
- Guaranteed Profits
With enough market knowledge and cost-benefit analysis, one can ensure that the profit is almost guaranteed regardless of the market conditions.
Box spreads are typically used in situations where the market is volatile, and traders are looking for a way to hedge their positions.
- Low Risk
Because the strategy creates a risk-free position, the risk associated with this strategy is relatively low.
- High-profits Probability
Although the potential rewards from a box spread trading strategy are relatively low, the probability of making a profit is high.
What Are the Risks Involved in Box Spread Trading?
Box spread trading strategy also comes with several risks that traders need to be aware of, including:
- Limited Profits
The profits that you can make from this strategy are limited to the difference between strike prices of call and put options. Furthermore, the high premium charges may negate the overall profits.
- Execution Risk
The success of the box spread trading strategy depends on your ability to execute the trades correctly. A mistake in execution could result in a loss. Therefore, it is more suitable for seasoned traders.
- Market Risk
Box spreads are typically used in situations where the market is volatile. If the market does not move in the expected direction, the strategy may result in a loss.
Overall, box spread trading is only profitable when the spread values are lower than the prevailing market price on the expiration date. It offers several benefits, like earning profits from adverse market movements with lower risks.
However, it also has several disadvantages, like high commissions, minimal profits, interest rate risks, etc. Therefore, traders who are considering using a box spread trading strategy should do so with caution and seek professional advice.
Frequently Asked Questions
What are the charges applicable to options trading?
Traders have to pay brokerage charges, Security Transaction Tax (STT), Goods and Services Tax (GST), stamp duty, margins, premiums, etc.
Should I implement box spread trading strategies as a beginner?
Box spread trading requires ample market knowledge to anticipate market momentum. Hence, it is generally suited for seasoned traders with market trade experience.
Can I use box spread trading for Nifty 50?
Yes, a box spread trading strategy can be implemented on any equity derivative including indices like Nifty 50.
What happens if the market price is lower than the strike price?
If the prevailing market price during expiration is lower than the strike price during expiration, then the contract stands unexercised and expires worthless. However, the buyer will have to pay premiums for buying call and put options.