Investors choose derivative trading for its high potential for diversification and for limiting their exposure to the fall of a specific asset class. Derivative trading includes two methods: Futures Contracts and Options Contracts. Investors who have a high-risk appetite generally choose Futures Contracts but investors who want to limit the risk still earn a hefty amount as profits go for Options Trading. Options are contracts that grant the holder the right but do not bind them, to either buy or sell a sum of some underlying asset at or before the contract expires at a fixed price.
One of the most beneficial things about Options Trading is the potential of executing numerous situational strategies. These tried and true strategies allow Options trades to utilize every stock market situation for profits. Among the Options traders, almost everyone implements Arbitrage strategies to earn small profits with little or no risks. These traders believe that they can increase the volume of such Arbitrage trades and earn hefty profits in the process.
Options traders often use various Spreads depending on the market situation. However, to make these Spreads more effective, an Options strategy called Short Box Strategy is executed. But, before you learn about the Short Box Strategy, you should learn about the two Spreads it combines.
What is Bear Put Spread?
The bear put spread strategy or bear put spread is when an investor sells a put option while simultaneously buying another put option with the same underlying asset and the expiration date. Investors use the bear put spread strategy when they believe that the market is bearish and the price of the underlying asset will go down moderately in a short period. The investors make profits through the difference in the strike prices of the two put options minus the net premium.
What is Bull Call Spread?
A bull call spread is an options trading strategy in which the trader buys and sells the same number of call options of different strike prices with the same underlying asset and expiration date. The strategy is used for a net debit in the premium as the premium paid is always higher than the premium received. However, the trader realizes profits if the price of the underlying asset rises with time.
Some terms associated with Short Box Options Trading Strategy
Strike Price: The price at which the options contract was initially bought or the pre-determined price.
Spot Price: The current price of the underlying asset is attached to the option contract.
Premium: It is the price you pay to the seller of the option for entering into the online trading options.
In-The-Money ITM call option: When the underlying asset price is higher than the strike price.
Out-of-the-money (OTM) call option: When the underlying asset price is lower than the strike price.
What is a Short Box Strategy?
Short Box Strategy is an Arbitrage Strategy that combines a Bull Call Spread and Bear Put Spread, having the same strike price and expiration date. The Short Box Strategy involves four simultaneous trades. I.e. selling a Bull Call Spread that includes an in-the-market call and out-of-the-market call, along with selling a Bear Put Spread that involves 1 in-the-market put and one 1-out-of-the-market put option. The Short Box Strategy is used by traders when they think that the Spreads are overpriced compared to their combined expiration value.
Understanding Short Box Strategy
Consider the following example to understand the Short Box Strategy:
Suppose ABC stock is trading at Rs 80 in August. For a trader to execute the Short Box, the following transactions are to be undertaken:
- September 75 Call - Rs 5
- September 85 Call - Rs 2.50
- September 75 Put - Rs 3
- September 85 Put - Rs 5
Sell Bull Call Spread: Sell 1 ITM Call + Buy 1 OTM call
Cost: (Rs 5x100) - Rs (2.50x100) = Rs 250
Sell Bear Put Spread: Sell 1 ITM put + Buy 1 OTM Put
Cost: (Rs 5x100) - Rs (3x100) = Rs 200
Total Cost of Short Box = Rs 450 (250+200)
Expiration value of Short Box: (Rs 85-Rs 75)x100 = Rs 1,000
Profit: Rs 1,000 - Rs 200 = Rs 800
Net Profit = Rs 800 - Taxes - Brokerage
If the stock price remains unchanged, the box will have a total value of Rs 1000. It will be valued at the same price if the stock climbs above Rs 85.
When should you use the Short Box Options Strategy?
The Short Box Options Strategy is entirely risk-free on the downside and very profitable on the upside. You can use a Short Box Options Strategy to earn better returns than other assets that come with a fixed interest rate. Overall, traders use the Short Box Options Strategy when they feel that the Spreads are overpriced compared to their expiration values. If they do, they hold the Short Box positions until the expiry to earn profits based on the difference in the strike price.
Risk and Reward associated with Short Box Strategy
Risks:
- It is one of the most complicated options strategies that need extensive financial knowledge to execute.
- It has high margin maintenance requirements, forcing traders to miss if they don’t have the capital.
- The profits are lower when compared to other options strategies.
- Traders have to wait until expiry, which can take months, to realize profits.
Rewards:
- It includes negligible risks, and there is no need to tie up capital.
- Being an Arbitrage strategy, it allows traders to earn small profits with no risk.
- Traders can increase the volume of traders to multiply their profits.
If you know what Bull Call Spread and Bear Put Spread are, you can combine them both to create a Short Box. As the Short Box Option Strategy carries no risk, you can earn good profits while mitigating your risk exposure. If you want to learn more about executing a successful Short Box, you can consult IIFL for expert financial advice and make informed decisions.
