Many people amplify their gains with options, which is popularized with YOLO bets on Reddit’s Wall Street Bets. Others use options as a hedge to limit their downside risk. A box spread is a hybrid of these.
Box spreads are an arbitrage strategy created by buying bull call spreads along with corresponding bear put spreads. Both spreads need to have the same strike prices and expiration dates.
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Example of a Box Spread
Let’s suppose you ABC stock is trading at $120 in January, and the following options are available:
- $100 March Put: $3
- $150 March Put: $20
- $100 March Call: $30
- $150 March Call: $2
Buying the bull call spread involves buying the March $100 call for $3,000 and selling the March $150 call for $200. The bull spread will cost $3,000 – $200 = $1,800.
Buying the bear put spread involves buying the March $150 put for $2,000 and selling the March $100 put for $300. The bear put spread will cost $2,000 – $300 = $1,700.
This makes the total cost of the box spread $1,800 + $1,700 = $3,500.
The expiration value of the box spread is ($150 – $100) x 100 = $5,000.
Therefore, an investor can make $1,500 is risk-free money by executing this box spread: $5,000 – $3,500 = $1,500 profit.
Example at Expiration
Let’s see what happens to this box spread at expiration. If ABC is $130 per share, the $150 call and $100 put are both worthless.
The $150 put is worth $20, while the $100 call is worth $30, or $50 total for the put and call. Since each option entitles you to 100 shares, your options are worth $5,000.
Box spreads are great because the strike price doesn’t matter. Suppose ABC goes down to $0 per share. Your $100 call will be useless, and both of your puts would be exercised.
- The $150 put that you own is worth $150 x 100 = $15,000
- The $100 put that you sold short is worth $100 x 100 = $10,000
- $15k – $10k = $5k
What’s the Catch?
If these box spreads allow you to make risk-free money, why isn’t everybody doing this?
It turns out that many hedge funds and machines are. Hedge funds invest billions of dollars in machines and technology to find these arbitrage opportunities before any human can catch them. Therefore, the odds of you finding an arbitrage opportunity with box spreads is incredibly low.
A Reddit user famously turned $5k into -$58k by using box spreads. The catch was that they bought American options, which can be exercised at any time. Once the call options sold short were exercised, the user had a -1,833% loss, and Robinhood closed their account.
What is a Box Spread – The Bottom Line
Box spreads are great in practice, but almost impossible to find in reality. By executing a set of call options and put options, an investor can lock in a riskless return over a set amount of time.
Unfortunately, hedge funds have invested billions of dollars in technology to find these opportunities before you do. Once they find an arbitrage opportunity, hedge funds will bid up the positions until the prices are greater than the locked in return.
If you ever believe you found a risk-free return with box spreads, make sure to ask around and dig deeper. You have better odds getting struck by lightning than finding a risk-free return, and the feeling will be similar once you realize your error.