Short Box Spread
The Short Box Spread is merely the opposite of the long box spread, where it is applied in options trading to take advantage of over-priced spreads rather than under-priced spreads. It's created by switching the positions from a long box spread, such that you'd sell a bull call spread and a bear put spread. It is an arbitrage strategy with the intention of earning a risk-free profit as it exploits some pricing inefficiency in option spreads.
The Short Box Spread Setup
Suppose XYZ stock is trading at $100. You could create a short box spread as follows:
- Sell a $100 strike call option and buy a $105 strike call option.
- Sell a $105 strike put option and buy a $100 strike put option.
All options have the same expiration date, and the strikes are chosen based on where you perceive the mispricing to occur.
The short box spread is recommended for sophisticated traders who can calculate the option prices and market accurately to take advantage of the price discrepancies. Such a strategy necessitates a strong level of precision in its implementation and is typically suited for an individual with more experience in the field of arbitrage options.
In short box spread
- Bull call spread: Short lower strike call and buy a higher strike call.
- Bear Put Spread: Sell a higher strike put and buy a lower strike put.
This strategy hopes to collect more premium from sold spreads than the price paid for bought spreads. In an ideal world, the end result of this setup will result in a net credit which is larger than the difference between the strike prices.
As is the case with its counterpart long, this short box spread does not bother to calculate its breakeven as the idea is to realize a sure and risk-free profit if priced just right in the perfect arbitrage.
The sweet spot for this strategy occurs when total premiums received from the sold options surpass the premiums paid for the bought options by more than the difference between the strike prices. That configuration guarantees a profit if held to expiration.
The maximum profit for the short box spread is the initial net credit received minus the difference between the strike prices. This profit is realized if the spread is established correctly and maintained to expiration.
Theoretically, there is no loss potential in a perfectly executed short box spread under true arbitrage conditions. Losses could occur due to mispricing, slippage, or incorrect execution.
These include execution risk: the spread positions may not be entered at optimal prices, and market risk if the spreads move against the direction before the position is fully established.
This strategy has neutral impacts from time decay because it has both long and short options. The effects of theta decay on the sold positions counterbalance the effects on the bought positions.
Changes in implied volatility are neutral to this strategy for the same reasons of time decay. Its performance would be more dependent on the initial pricing and setup rather than subsequent changes in volatility.
The short box spread is an advanced arbitrage strategy used to exploit overpriced option spreads. It provides the opportunity for a risk-free profit in ideal conditions but requires accurate execution and a deep understanding of option pricing and market dynamics. Due to its complex nature and execution requirements, it is best suited for highly experienced traders.