Combining the Bear and Bull in the Option Box Spread
Many option strategies are designed to create profit potential and also reduce risk. If you are willing to accept a limited level of both profit and risk, many spreads will do the trick. These strategies are complex, however, and might not be worthwhile given the transaction cost and need to monitor positions constantly. One example is the box spread.
Spreads can be broadly defined as bull or bear. Either may be constructed using calls or puts. In a box spread, you combine bull and bear spreads to eliminate risk and create a form of option-based arbitrage. If the net cost/credit of the spread and the expiration profit both work in your favor, then you can realize small profits from these positions.
Dangers of the box spread is that in analyzing it, you can easily overlook the risk of early exercise. Margin requirements might additionally place a demand on your available capital for only a small potential return.
If the underlying security moves significantly while the box spread is open, you need to understand the worst-case scenarios as well as the elegant best-case scenario you hope for in this position.
An example: On July 15, 2012, Kinder Morgan Energy Partners (NYSE: KMP) closed at $84.19 per share. At that time, August calls and puts were valued so that the following box spread could be opened:
For $288, you create a box spread, parts of which increase in value or decrease in value regardless of the direction of price movement in the underlying. At any point above or below these strikes, half of these positions will be in the money and the other half out. Each will consist of one long and one short position.
If the price rises, profits build in the long call and the short put; if the price declines, profits build in the long put and the short call.
This position is promising if you look only at profit potential. But both the short call and the short put present exercise dangers. This example involves Out of the Money ('OTM') options and with In the Money ('ITM') options. A profit cushion can be built into a box spread as long as current price resides in between the strikes.
For example, if the stock is currently at $84 per share and the box spread includes positions at $82.50 and $85. So if all of the prices remain between those strikes. However, proximity is only one factor in evaluating the box spread accurately. Of much greater concern is the exposure to short option expirations.
Traders are likely to believe they will close positions when they become profitable. That is the likely outcome, but what happens to the positions left open? The long position is going to expire worthless, but the short position will be exercised or has to be closed at a loss or rolled forward. This is where the box spread is questionable.
Depending on how much movement you experience in the stock, you could end up with an exercise that eliminates any chance of profits. In the example, the net cost of the box spread was $288; but this is only the initial cost.
The ultimate cost including losses upon exercise could be much higher; and if you do end up closing either long or short positions before expiration, you need to offset and surpass the $288 (plus transaction costs) to make a profit. This could be quite a challenge.
The box spread looks great on paper. In reality, risk assessment is the key to understanding why complex strategies like this do not always work out profitably. Beyond the appearance of a “sure thing,” the true risks should determine whether or not a box spread makes sense.
To decide whether any position makes sense, time your entry to coincide with implied volatility. The test of options viability is in identifying levels of volatility to better time entry and exit.
This is a difficult task, you will benefit by getting help just focusing on volatility for this important timing of trades. To improve your option trade timing, check the Benzinga service Options & Volatility Edge which is designed to help you improve selection of options as well as timing of your trades.