Long Box
The Long Box Spread is an options trading strategy that uses the difference in option price anomalies to exploit these differences. This strategy creates a position that synthetically replicates a risk-free bond. This strategy is accomplished by entering simultaneously into a bull call spread and a bear put spread that have the same strike prices and expiration dates. It is normally used when the net cost of the spreads is less than the spread between their respective strike prices, indicating market price misrepresentation.
The Long Box Setup
Assume XYZ stock is selling at $100. This is how you may structure a long box:
- Buy a call option with a $100 strike price and sell a call option with a $105 strike price.
- Buy a put option with a $105 strike price and sell a put option with a $100 strike price.
All of the options have the same expiration date. The structure is designed to take advantage of the price arbitrage between the options.
The long box spread is best suited for traders who have identified certain price inefficiencies in options markets and are seeking to capitalize on arbitrage opportunities. It is a complex strategy that requires exact execution and, therefore, typically is used only by experienced traders.
This strategy is the combination of a long bull call spread and a long bear put spread as well:
- Bull Call Spread: Buy a call at a lower strike and sell a call at a higher strike.
- Bear Put Spread: Buy a put at a higher strike and sell a put at a lower strike.
The goal is to have the strategy set up at a cost that is less than the difference between the strike prices. The final position is essentially risk-free, as it locks in a fixed payout at expiration, regardless of the underlying asset’s price movements.
The breakeven points of a long box spread rarely come into play since the strategy is designed to ensure a certain return if correctly priced and executed.
The sweet spot for this strategy is when it is established for a net debit that is less than the difference between the strike prices of the options used in the spread. This would ensure a risk-free profit at expiration.
The maximum profit for a long box spread is the difference between the strike prices minus the net cost of setting up the spread. If the spread is set up correctly under arbitrage conditions, the profit is locked in immediately upon execution.
Under perfect arbitrage conditions, there should be no risk of loss in a well-executed long box spread. Losses would occur due to errors in execution or changes in price between the time of establishing the positions and the time of execution.
Mispricing or the gap closes unsympathetically in the time it takes to establish the spread, and a net debit turns out to be equal to or greater than the difference between the strike prices.
Time decay (theta) is neutral in this strategy as well since the positive effects of the decay on the long position are offset by its negative effects on the short position.
Since long positions are balanced by short positions, changes in implied volatility do not have much of an effect on this strategy. The strategy is more designed to exploit price inefficiencies rather than directional moves in volatility.
Long box spread is one of the complex trading strategies used mostly for arbitrage. Provided the transaction goes perfectly, it offers the opportunities to exploit market imperfections for a risk-free profit. However, its complexity and the rigid requirements for its execution make it suitable only for sophisticated investors who are comfortable with intricacies of options pricing and how the markets behave.