What is a Box Spread?
A box spread is a special kind of options trading strategy. Options are a type of financial product that give you the right to buy or sell something, called the underlying asset, at a specific price by a certain date.
How Box Spreads Work
When you do a box spread, you create a position that acts like you bought the underlying asset at one price and sold it at a different price. You do this by buying and selling multiple options contracts of different types at the same time:
Long Call, Short Put
First, you buy a call option and sell a put option. This combo is sometimes called a “synthetic long position.” It’s almost like you purchased the underlying asset.
The call option gives you the right to buy the underlying at a certain price (the “strike price”). The put option you sold gives someone else the right to sell you the underlying at the strike price.
Short Call, Long Put
At the same time, you also sell a call option and buy a put option at a different strike price. This is like a “synthetic short position,” similar to shorting the underlying.
The call option you sold gives someone the right to buy the underlying from you at the strike price. And the put option you bought gives you the right to sell the underlying at the strike price.
Why Use Box Spreads?
If the two synthetic positions have different net prices, you can make an arbitrage profit. Arbitrage means buying and selling the same thing at different prices to make a risk-free gain.
Box spreads lock in this gain right away. The potential profit is limited, but so is the risk. In fact, the risk is usually considered very low, close to zero (if done properly).
European-Style Box Spreads
A special case is box spreads using European-style options. These can only be exercised at expiration.
If you make a box spread with European options, the payoff pattern will be just like a zero-coupon bond. Zero-coupon bonds pay no interest but are sold at a discount and pay full face value at maturity.
Risks of Box Spreads
While box spreads are considered very low risk when done right, there are still some dangers to know:
Early Exercise Risk
One risk comes from the short options positions. If those options get exercised early, it can mess up the arbitrage.
This isn’t an issue with European options, but American-style options can be exercised any time. If the short legs are exercised while the long legs are held to expiration, money can be lost.
Execution and Slippage Risk
Another issue is that box spreads involve four separate options trades. The profit depends on getting good fill prices on all of them.
Slippage during order entry, or bad fills from wide bid-ask spreads, can cut into the expected gain. Fees and commissions also have to be factored in.
Pinning Risk
Box spreads make money based on the difference between the two strike prices. But if the underlying asset is very close to one of the strikes at expiration, funky things can happen.
The options might not be exercised as expected. This situation, known as “pinning,” can throw off the hoped-for payoff.
The Infamous “1R0NYMAN” Box Spread Incident
One famous example of box spreads going wrong was the case of the Reddit user “1R0NYMAN” in 2018.
This trader thought he had found a foolproof arbitrage using box spreads on S&P 500 options. He took a huge position, failing to see the assignment risks.
When some of his short puts were assigned, he ended up deep in the red. 1R0NYMAN lost over $50,000, pretty much wiping out his account.
The painful lesson was that no trade is completely risk-free. Even if the math behind a strategy looks sound, operational risks and “unknown unknowns” are always lurking.
Frequently Asked Questions
What is the maximum profit of a box spread?
The max profit is locked in at the start of the trade. It equals the difference between the net debits or credits of the two “sides” of the box.
What is the breakeven point for a box spread?
There really isn’t a breakeven point, in the normal sense. If the box is held to expiration and no legs are exercised early, the profit or loss is fixed from the beginning. It doesn’t depend on the price of the underlying.
Can you lose money on a box spread?
The typical intention is to guarantee a profit, however small. But as described above, things can go wrong. Early assignment or adverse pin risk can lead to losses. Slippage and fees can also eat into the “guaranteed” profits.
What is a box spread used for?
Box spreads are mainly used by big institutions and professional traders. They can be used to lock in an interest rate to borrow or lend money at.
Traders also use them for arbitrage. If executed perfectly, they offer a small but certain profit.
What is a long box spread vs short box spread?
A long box spread is when the higher strike synthetic position is bought and the lower one sold. This has a net debit, like buying a bond.
A short box is the opposite – selling the higher strikes and buying the lower ones. This has a net credit, like shorting a bond.
Are box spreads legal?
Yes, box spreads are a legitimate trading strategy. Some brokers may not allow them or put special requirements on them, though.
Regulators keep an eye out for large box spread positions that might represent hidden leverage or unusual borrowing/lending arrangements. But in general they are allowed.
Why are box spreads forbidden?
Box spreads aren’t universally forbidden, but some brokers don’t allow them. This might be because:
- They can involve a lot of margin and risk if done in large size
- They can tie up a lot of capital for a small profit
- There are risks that the trade might not work as intended
- It may look to regulators like the trader is trying to hide something
So while not illegal, some firms decide the potential risks and complexities aren’t worth it. Especially with retail traders, they may just say no to box spreads.
