Options Trading 101: The Box Spread

The box spread is a trading strategy that seeks to accumulate a rate of return near that of an interest-rate bond. Using the box spread entails buying puts and calls. Given it is an arbitrage strategy, there is no real risk in using the box spread. The only downside is the transaction costs because of all the calls and puts used.

Essentially, the box spread entails buying a bull call spread and buying a bear put spread. Because these two strategies even each other out at the time of expiration, the goal of the box spread is to find discrepancies in options market prices that would afford the strategy more than a risk-free rate of return.

The above-mentioned goal is the idea of arbitrage, which should be the above and beyond rate of return that does not accompany the utility of risk that a comparing investment or comparing strategy would have to bear. For instance, a box spread priced at a net present value that equates to an annualized rate of return of 5% compared to a risk-free interest rate annualized at 4% means that the investor can establish the box spread profitably by one percent.

During times of financial crisis, credit and bond markets freeze to the point of economic instability. That means that interest rates have to dip low in order to bring markets back to equilibrium. Recently, as this has happened, volatility and trading activity has increased coincidentally. This is very significant for options traders, especially professional traders who are making use of the box spread, because highly liquid and unstable markets usually mean options markets are not in equilibrium. This makes for some great financial capacities for large counter-parties. Imagine a time when major financiers cannot borrow money from banks.

More casual traders may also take advantage of the box spread so long as the transaction costs do not curtail the arbitrage opportunity. Box spreads deal with close margin figures; therefore, any transaction costs that are not discounted to allow low margin investment returns would render the entire strategy futile if not counterproductive.

Another discouraging factor for the box spread strategy is that it is very difficult to execute. The bull call spread and the bear put spread are lost in complexities come time of executing the trade. With that said, your local broker or trading firm can pretend to comprehend box spreads and be more than willing to pursue the strategy; however, when it is time to impute the trade, you can be safe to expect a margin of error that could render the entire strategy counterproductive. If you are serious about box spreads, you would need a high performance trading terminal or computer and electronic trading platform to ease the analysis and imputing of trades.

All in all, box spreads are highly beneficial for those who understand them and do not mind receiving investment-grade bond returns without bearing the risks of default nor reinvestment risk.