The similarity of the two spreads in regards to their expiration dates and strike prices is what constructs the ‘box’ that surrounds the stock price.
The long box strategy is commonly used where the spreads are undervalued compared to their expiration values. It is a risk-free arbitrage strategy because the risks are already determined, though its profits are limited.
Long Box Spread Pay Off Diagram
Here’s long box spread’s P&L diagram
There’s quite a bit going on so let’s take each element in turn.
The dashed blue lines represent the four options in the spread: the long and short puts, and the long and short calls.
The puts combine to form a bear put spread, and the calls form a bull call spread. Thin double lines represent both spreads.
The combination of these spreads is the red line: the long box spread payout.
Notice that this small but positive for all possible expiry prices meaning that the spread is risk free; it’s an example of an arbitrage trade.
Note that in a perfectly efficient market this should not occur, but because markets are often inefficient (especially during times of high volatility) such opportunities for risk free profits can occur.
It is important, however, to move quickly as the market should correct such arbitrage opportunities over time.
What Is A Long Spread?
A long put spread is the difference derived from buying a put option and then selling it on the same underlying asset with the same expiration date but a lower exercise price.
On the one hand, a long put spread obligates you to buy the stock at a low strike price (say A) but gives you the right to sell it at a higher strike price (say B).
It is an alternative to buying a long put because selling a low-priced put at strike price A compensates for the cost of the put if you purchased it at strike price B. In this way, the long out spread limits your risk.
On the other hand, a long call spread allows you to purchase the put at the lower strike price A and obligates you to sell it at the higher strike price B, in the event you are assigned.
The long call spread strategy is an alternative to buying a long call because selling at a higher strike price, B, offsets the lower cost paid for it. The trader avoids losses, but this risk reduction comes at a cost because they must forfeit some profits.
When To Put On
For it being a risk-free arbitrage strategy, the long box strategy earns better returns than the earnings you would get from your fixed deposits. However, your earnings will often vary depending on your chosen strike prices.
For this reason, this strategy is best suited for use when the spreads are underpriced in relation to their expiration dates. Even then, the trader must keep this position open until the day of expiration if he is to gain any profits from the strike price difference.
Ideally, the long box strategy is a reserve for the advanced traders rather than the small subsistence traders because the professionals have the resources to monitor the arbitrage opportunities using high-frequency algorithms that most small traders do not have or cannot use.
Also, the large experienced traders can afford to raise the large capital amount that this strategy demands to make any substantial profits. But, even then, the brokerage fees or commissions should remain minimal because these payables could eat into the profits earned.
Pros of the Long Box Spread Strategy
- It is an arbitrage trading strategy with no risks to your profits
- It’s a neutral strategy whose gains are not influenced by the direction of the price of the underlying stock
Cons of the Long Box Spread Strategy
- Produces minimal profits that can be easily wiped out if a trader is paying commissions for brokerage services
- The trader must keep the position open until the day of expiry
- It has high capital requirements to achieve a profit margin, and most traders cannot afford it
- It’s only suited to professional traders with the experience and expertise needed to spot arbitrage opportunities and a large capital reserve to take advantage of the small profit margins that come up
What Are The Risks?
The long box strategy is relatively low-risk because the gains in one spread offset the losses in the other spread. Another reason is that the strike prices are guaranteed. Yet, still, some minimal inefficiencies come up, and you could consider them risks. They are:
- An offsetting transaction may promptly erode the box spread during an exchange, resulting in some profit or loss.
- The trading costs, which include the brokers’ fees and the taxes could turn the trade into a loss-making venture
When To Take Off A Long Box Spread
The time to take off a long box spread is when the economy has stabilised. The reason is that the long box options strategy is only used when the economy is just beginning to recover from a financial crisis, at the turn of a depression.
During the depression, the bond and credit markets stiffen, causing economic instability. But, at the start of the recovery, interest rates start to dip very low as market forces work to bring the economy back up to equilibrium. At this time, trading and, consequently, market volatility starts to resume, and this is the time to enter into a long position. The market environment is now ripe with significant financial gains for traders who place large counterparties.
But, once the market stabilises, traders in long positions let their options expire worthless because the price of the underlying assets is higher than the options strike price, choosing to trade the stocks instead.
Possible Adjustments/ Risk Mitigation
Traders do not typically adjust long box spreads because the strategy delivers on its potential to yield profitability amidst price inefficiencies from the point of entry.
The aim of getting into the ‘box’ is usually to buy two debit spreads and to get them at a price lower than the width of the spreads. If the trader gets this bargained deal and can sustain the open position, the trade will be successful because he shall sell the option at the promised strike price on the expiration date, at a price higher than what he paid.
Nonetheless, due to the nature and pricing of the box spreads, they are highly susceptible to the risks of early assignment. The assignment and its associated costs could cost much more than the amount in the account, and the trader would suffer a significant loss.
To that end, anyone using the risk-free long box options strategy must first be aware of the possibility of incurring large losses that come with assigning the options before their expiration.
The long box options trading strategy is an excellent tool to take advantage of the market inefficiencies resulting from an economic decline.
So long as you wait for the option to expire, you are bound to gain an assured profit margin, which is critical, especially when other financial instruments are suffering the effects of an economic downturn.