Box Spreads

When you open a bull spread and a bear spread at the same time, using options on the same underlying stock, it is called a box spread. This limits risks as well as potential profits, and is designed to produce a profit in one side or the other, regardless of which direction the stock moves.

In this example below, if the underlying stock's price moves significantly in either direction, portions of the box spread can be closed at a profit. One important reminder: It makes sense to close corresponding long and short positions in the event of a profit opportunity, to avoid the risk of leaving yourself exposed with an uncovered short option.

In the ideal situation, the stock's price will move first in one direction (enabling half the box spread to be closed at a profit) and then in the other (enabling the close of the other half, also at a profit).


Example

Boxed in with Options: As illustrated in Figure below, you create a box spread by buying and selling the following option contracts:
  • Bull spread: Sell one September 40 put and buy one September 35 put.
  • Bear spread: Buy one September 45 call and sell one September 40 call.
[caption id="attachment_12551" align="aligncenter" width="440"]Example of box spread. Example of box spread.[/caption]


Smart Investor Tip

When one side of the box spread expires, you might be left exposed on the other side. Keep an eye on the changing situation to avoid unacceptable risks.

The detailed profit and loss zones of a box spread are summarized in Figure below. The net proceeds from this box spread result from the following outcomes:

[caption id="attachment_12552" align="aligncenter" width="400"]Box spread profit and loss zones. Box spread profit and loss zones.[/caption]


If the stock's market price rises to between $40 and $45 per share, the bull spread can be closed at a profit. Above that level, the difference in bull spread values will move to the same degree in the money, offsetting one another. At that level, you can wait out time value decline, but it could also make sense to close the position when profits are available, if only to avoid exercise.

If the stock falls to between $35 and $40 per share, the bear spread can be closed at a profit. The long December 40 will be in the money and will change point for point with change in the stock's price. Below the level of $35 per share, the long and short position will change in intrinsic value levels, offsetting one another. Closing in-the-money positions makes sense to avoid exercise, remembering that time value offsets are likely to minimize any additional profits you could earn from waiting any longer.

Smart Investor Tip

When you close part of a box spread, close related long and short positions to avoid leaving open uncovered short positions.

By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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