What is a box spread?

A box spread is an investment strategy that involves the combination of four options to create a set payoff at a future date when the options expire. This strategy is often considered to be similar to fixed-income products, such as zero coupon bonds, due to its payment characteristic, which delivers a fixed amount at the end of a specified period.

How do you construct a box spread?

A box spread is constructed with a combination of two call options and two put options at two different strike prices. This combination is often referred to as a pair of call spreads and put spreads with matching high and low strikes. Pairing the two spreads together creates an offsetting payment structure that results in a constant payoff value, regardless of the price of the underlying asset at expiration.

How does a box spread work?

While a box spread is often described as a pair of call spreads and put spreads, this representation may not best explain how a box spread works. A more intuitive understanding of a box spread is as a pair of synthetic long and short positions at two different strike prices.

Synthetic option positions result in an actual long or short position at the chosen strike price when the option spread is held to expiration. This means that at expiration, the trader is obligated to buy the underlying at one price and sell it at another price. The trader is both long and short the underlying security, resulting in a constant payoff that is indifferent to any price changes in the underlying. The difference between the two strike prices determines the amount owed after the subsequent buy and sell at expiration.

What is the purpose of a box spread?

Investors can take either a long or short position in a box spread. When taking a long position, an investor lends the value of the spread and is owed the difference in strike prices at expiration. On the other hand, when taking a short position, the investor borrows the value of the spread and agrees to pay back the difference in strike prices at expiration.

The size and maturity of a box spread can be adjusted by selecting different strike prices and option expirations. The larger the difference in strike prices, the greater the amount loaned, and the farther away the expiration, the longer the duration of the loan. It's important to note that the availability of option strikes and expirations for a specific underlying security may limit the size and maturity of a box spread.

The effective interest rate of a box spread can be calculated by considering the current value of the spread, the difference between strikes as the future value at expiration, and brokerage and exchange fees. Brokerage and exchange fees play an important role in the cost of the spread, and are typically per option leg, so a box spread will likely incur each fee four times per trade. The cost of the spread, including brokerage and exchange fees, will differ from the price reported to the market, which excludes fees. Larger spreads and farther expiration dates generally result in proportionally lower fees, making the spread closer to market interest rates.

What are the risks of using a box spread?

Box spreads come with a number of inherent risks that traders should be aware of. One important risk is the need to maintain positions in all four option legs in order to ensure that the net value of the box spread remains fixed. This is important because the price changes of the underlying security can affect all four option legs differently, potentially altering the value of the box spread and introducing increased downside risk. To mitigate this risk, all four option legs should be traded as a single option spread trade and only used with European options, which cannot be exercised early.

In the case of options trading, the risk of a counterparty not fulfilling their obligations can arise. This risk can become particularly pronounced during market disruptions or in the event of a default by a clearing member. While some central clearinghouses, such as the Options Clearing Corporation (OCC) in the US, guarantee the performance of options contracts traded on exchanges, this guarantee may not always be sufficient to fully protect traders from counterparty risk. It is important for traders to be aware of and manage this risk in their investment strategies.

Liquidity risk is another factor to keep in mind for investors utilizing box spreads in their portfolios. The risk arises from the possibility of difficulty in finding counterparties to execute trades. Due to the complex nature of box spreads as four-legged option spreads, they generally have lower liquidity compared to their individual option legs. In addition, just like other securities, box spreads are also susceptible to market liquidity risk, which can manifest during market disruptions resulting in a sudden drop in market liquidity. In these scenarios, finding buyers or sellers for any type of security becomes challenging, making it difficult for investors to unwind their positions, leading to potential significant losses.

Similar to other fixed-income instruments, box spreads are susceptible to interest rate risk. This means that when market interest rates rise, the value of the box spread may decline, and conversely, when interest rates fall, the value of the box spread may appreciate. This creates an uncertain outlook for traders, making it more difficult to predict the future performance of the spread. Nevertheless, like other fixed-income instruments as well, holding a box spread until expiration will eliminate the influence of interest rate changes.

Finally, it's worth noting that box spreads are a relatively complex strategy and may not be suitable for all investors. It typically requires an understanding of options trading. It's important to consult with a financial professional before attempting to trade box spreads.