Short Box (Arbitrage) Option Trading Strategy Explained

Published on Thursday, April 19, 2018 | Modified on Monday, October 26, 2020

Short Box (Arbitrage) Options Strategy

Strategy Level	Advance
Instruments Traded	Call + Put
Number of Positions	4
Market View	Neutral
Risk Profile	None
Reward Profile	Limited
Breakeven Point

Short Box is an arbitrage strategy. It involves selling a Bull Call Spread (1 ITM and I OTM Call) together with the corresponding Bear Put Spread (1 ITM and 1 OTM Put), with both spreads having the same strike prices and expiration dates.

The short box strategy is opposite to Long Box (or Box Spread). It is used when the spreads are overpriced with respect to their combined expiration value.

This strategy is the combination of 2 spreads (4 trades) and the profit/loss calculated together as 1 trade. Note that the 'total cost of the box remain same' irrespective to the price movement of underlying security in any direction. The expiration value of the box spread is actually the difference between the strike prices of the options involved.

The usual box spread look like as below for NIFTY current index value as 10550 (NIFTY Spot Price):

Note:

• Call Spread meaning 2 calls, one ITM and one OTM.
• Put Spread meaning 2 puts, one ITM and one OTM.
• ITM is 'In the money' and OTM is 'Out of the money'. For Nifty Spot Price at 10550, the 10400 Call Option is ITM and 10700 Call is OTM.
• Arbitrage strategy is a way to earn small profits with very little or zero risk. In this a trader buys the call and put have the same strike value and expiration The resulting portfolio is delta neutral.

As you see in the above table, this is a delta neutral strategy. The trader is selling and buying equivalent spreads. As long as the price paid for the box is significantly higher than the combined expiration value of the spreads, a riskless profit can be earned. We will discuss this in detail in an example below.

As the profit from the short box is small. In many cases it is offset by the expenses i.e. brokerage and taxes. It's very important to consider the trading cost (brokerage, fee, taxes etc.) before trading in this strategy.

When to use Short Box (Arbitrage) strategy?

Being risks free arbitrage strategy, this strategy can earn better return than earnings in interest from fixed deposits for any investor. The earning from this strategy varies with the strike price chosen by the trader. i.e. Earning from strike price '10400, 10700' will be different from strike price combination of '9800,11000'.

The short box strategy should be used when the component spreads are overpriced in relation to their expiration values. In most cases, the trader has to hold the position till expiry to gain the benefits of the price difference.

Note: If the spreads are underpriced, another strategy named Long Box (or Box Spread) can be used for a profit.

This strategy should be used by advanced traders as the gains are minimal. The brokerage payable when implementing this strategy can take away all the profits. This strategy should only be implemented when the fees paid are lower than the expected profit.

Example

Short Box Example 1

Let's take a simple example of a stock trading at Rs 55 (spot price) in June. The option contracts for this stock are available at the following premium:

• July 50 call - Rs 7
• July 60 call - Rs 1.50
• July 50 put - Rs 2
• July 60 put - Rs 7

Lot size: 100 shares in 1 lot

1. Sell a Bull Call Spread = Sell 'July 50 call' + Buy 'July 60 call'

   Bull Call Spread Cost = (Rs 7*100) - (Rs 1.5*100) = Rs 550

2. Sell Bear Put Spread = Sell 'July 60 put' + Buy 'July 50 put'

   Bear Put Spread Cost = (Rs 7*100) - (Rs 2*100) = Rs 500

The total cost of the box spread is: Rs 500 + Rs 550 = Rs 1050

The expiration value of the box is computed to be: (Rs 60 - Rs 50) x 100 = Rs 1000

Profit: Rs 1050 - Rs 1000 = Rs 50

Net Profit = Rs 50 - Brokerage - Taxes

In above example, since the total cost of the box spread is higher than its expiration value, a risk-free arbitrage is possible with the short box strategy. Now let's discuss about the possible scenarios:

Scenario 1: Stock price remain unchanged at Rs 55

The July 50 put and the July 60 call expire worthless while both the July 50 call and the July 60 put expires in-the-money with Rs 500 intrinsic value each. So the total value of the box at expiration is: Rs 500 + Rs 500 = Rs 1000.

Scenario 2: Stock price reaches to Rs 60

Only the July 50 call expires in-the-money with Rs 1000 in intrinsic value. So the box is still worth Rs 1000 at expiration.

Scenario 3: Stock price falls to Rs 50

A similar situation as scenario 2 happens but this time it is the July 60 put that expires in-the-money with Rs 1000 in intrinsic value while all the other options expire worthless. Still, the box is worth Rs 1000.

In all the possible scenarios, the box worth remains at Rs 1000 on expiry resulting in profit of Rs 50.

Short Box Example 2

Let's take an example of NIFTY Options which is traded in lot size of 75.

Note the Net Profit changes when you buy options at different the strike price using the same strategy.

Market View - Neutral

The market view for this strategy is neutral. The movement in underlying security doesn't affect the outcome (profit/loss). This arbitrage strategy is to earn small profits irrespective of the market movements in any direction.

Actions

• Buy Call Option 2
• Sell Call Option 1
• Buy Put Option 2
• Sell Put Option 1 (2>1)

Say for XYZ stock, the component spread is relatively overpriced than its underlying. You can execute execute Short Box strategy by selling 1 ITM Call and 1 ITM Put while buying 1 OTM Call and 1 OTM Put. There is no risk of loss while the profit potential would be the difference between two strike prices minus net premium.

Simillar Strategies

• Box Spread or Long Box