What is a Box Spread?
The box spread is a strategy that comes into play in the practice of options trading. The idea behind a box spread is to create a situation in which there is zero risk in regard to the payoff of the actions taken in the strategy. This essentially involves creating a chain of events that results in a no arbitrage assumption. The total of the net premium used in the acquisition process is to be equal to the present value of the payoff on the transaction.
Box spreads make use of a series of puts and calls to obtain the desired result. Within the context of this strategy, the investor may choose to follow a bull spread with a bear spread in order to create the desired balance between premium and payoff. The bull spread may involve a long call option coupled with a short call option that is then followed by a bear spread that involves a long put option and a short put option. This series of transactions, when diagrammed, can easily be demonstrated in the form of a rectangular box, resulting in naming the procedure a box spread.
Several factors can determine if a box spread is a feasible option for the investor. The condition of arbitrages plays a central role, since the balance of the results is directly impacted. Executing the puts and calls properly will also make a big difference to the success of the strategy. Choosing to short the wrong call, for example, will throw the entire equation out of line, and not result in the balance between the net premium and the present value that was hoped for.
It is possible to create two different variations of the box spread. The long box spread will involve the utilization of four options, generally with the same underlying asset and the same terminal or payoff date. This is different from the short box spread, which will usually involve two options. In both instances, the same basic combination of puts and calls is used.
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