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OX Preads

The document discusses box spreads, which involve a combination of a bull call spread and a bear put spread using the same two strike prices. A box spread allows an investor to lock in riskless profits if put-call parity is violated in the options market, presenting a market inefficiency. The document provides an example of a long box spread, where the discounted payoff is higher than the market price, and a short box spread, where the discounted payoff is lower. It explains how to establish the positions, potential profits, and limitations of this strategy.

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Udayan Bhattacharya
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© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
61 views

OX Preads

The document discusses box spreads, which involve a combination of a bull call spread and a bear put spread using the same two strike prices. A box spread allows an investor to lock in riskless profits if put-call parity is violated in the options market, presenting a market inefficiency. The document provides an example of a long box spread, where the discounted payoff is higher than the market price, and a short box spread, where the discounted payoff is lower. It explains how to establish the positions, potential profits, and limitations of this strategy.

Uploaded by

Udayan Bhattacharya
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 22

BOX

SPREADS

RECALL: BULL CALL SPREAD

Executed when investors think that stock prices


will go up.

RECALL: BEAR PUT SPREAD

Executed when investors think that stock prices


will go down.

THE BOX SPREAD

Combination of a Bull Call and a Bear Put


Involves 4 options and 2 strike prices

WHY THE BOX SPREAD WORKS


The investor refuses to make a bet on the
movement of the stock price, but knows that
there is a market inefficiency.
There is no need to invest in the underlying
stock.
The investor wants to lock in a riskless profit.
This strategy results in no possible losses and
limited profits.

EXAMPLE 1:
Given:
Today is February. The stock price of ABC is
trading at $38. Its options are:

Mar 30 put: $1.50


Mar 40 put: $5
Mar 30 call: $6
Mar 40 call: $1

Risk free rate for all maturities: 8%

TESTING THE PUT-CALL PARITY

Stock price: $38


Mar 30 put: $1.50
Mar 40 put: $5
Mar 30 call: $6
Mar 40 call: $1
Risk Free Rate: 8%

Conclusion: The Put-Call Parity does not hold and


there is a market inefficiency in option prices
Tip! Set K2 as the option with the higher strike price
It will help in the next slides

HOW DO YOU TAKE ADVANTAGE OF THIS?


You now know theres a market inefficiency. The
next thing to do would be to know how to position
your options.
First Step: Set up the ff equations: (Remember
our tip before where K2 is the bigger strike
price?)

This equation reduces to:

Note: K2 is the bigger strike price so that the discounted payoff


is positive and thus, comparable to market value

HOW DO YOU TAKE ADVANTAGE OF THIS?

Rearranging:

Next: Determine the market price and compare it


with the discounted payoff.

strategy: Long Box Spread


strategy: Short Box Spread

LONG BOX SPREAD

Market Price: $8.5

Following this equation:

Strategy would be:


Long on Mar40 put
Short on Mar30 put
Short on Mar 40 call
Long on Mar30 call

Note: follow the signs to determine your strategy if positive,


long. If negative, short

PROFITS AND PAY-OFFS


Stock Price at Exercise Date
Payoff From Call Options
Short on March 40 call
Long on March 30 call
Payoff from Put Options
Short on March 30 put
Long on March 40 put
Total Profit

20

25

30

35

-6

-6

-6

-6

10

10

10

1.5

1.5

1.5

1.5

-5

-5

-5

-5

1.5

1.5

1.5

1.5

PROFITS AND PAY-OFFS


Stock Price at Exercise Date
Payoff From Call Options
Short on March 40 call
Long on March 30 call
Payoff from Put Options
Short on March 30 put
Long on March 40 put
Total Profit

40

45

50

55

10

10

10

10

-6

-6

-6

-6

1.5

1.5

1.5

1.5

-5

-5

-5

-5

1.5

1.5

1.5

1.5

GRAPH OF A LONG BOX SPREAD

Profit
Call Options

Put Options

Stock Price

EXAMPLE 2
Given:
Today is September. The stock price of EFG is
trading at $45. Its options are:

Oct 40 put: $2
Oct 50 put: $7
Oct 40 call: $7
Oct 50 call: $1.5

Risk free rate for all maturities: 8%

EXAMPLE 2:
The Put-Call Parity was violated.
Compare the market price and the discounted
payoff.

Determine your strategy


Short Box Spread

SHORT BOX SPREAD

Market Value: $10.5

Modify this equation:

New equation:
__

Strategy would be:


Short on Oct 50 put
Long on Oct 40 put
Long on Oct 50 call
Short on Oct 40 call

PROFITS AND PAY-OFFS


Stock Price at Exercise Date
Payoff From Call Options
Long on Oct 50 call
Short on Oct 40 call
Payoff from Put Options
Long on Oct 40 put
Short on Oct 50 put
Total Profit

35

40

45

50

-5

-10

-1.5

-1.5

-1.5

-1.5

-10

-10

-5

-2

-2

-2

-2

0.5

0.5

0.5

0.5

PROFITS AND PAY-OFFS


Stock Price at Exercise Date
Payoff From Call Options
Long on Oct 50 call
Short on Oct 40 call
Payoff from Put Options
Long on Oct 40 put
Short on Oct 50 put
Total Profit

55

60

65

70

-10

-10

-10

-10

-1.5

-1.5

-1.5

-1.5

-2

-2

-2

-2

0.5

0.5

0.5

0.5

GRAPH OF A SHORT BOX SPREAD

Profit

Stock Price

RECAP:
Determine if theres an inefficiency in the
market.
Find the discounted payoff and compare it with
the market price of the box spread today.
Long Box Spread
Short Box Spread
Determine how to establish the bull spread and
bear spread. Note: this is the follow the sign strategy
Enjoy the riskless profits while they last! The
market will soon clear out this arbitrage
opportunity

LIMITATIONS
It is hard to spot and take advantage of such
arbitrage opportunities.
The price differences quickly balance off, making
it hard to take a position.
This is not an ideal strategy for small investors
because the commission will eat up the profits.
It can be difficult to justify the small profits given
the high commissions paid.

THE END
Cua, Meredith
Te, Aimee
Wong, Leigh

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