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The Box Spread - Limited Profit And Loss Or Questionable Strategy?

|Includes:Wells Fargo & Co. (WFC)
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Some option strategies are elegant in the sense that they create an exchange of profit potential and risk. If you are willing to accept a limited profit in exchange for eliminated risk, some spreads work well. However, these strategies also tend to be complicated, so you have to question whether entering them is worthwhile.

One example is the box spread.

Basic spreads include bull and bear versions. Either of these can consist of 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 create small profits from these positions.
One danger to the box spread is that in analyzing it, you can easily overlook the risk of early exercise. If the underlying stock 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 January 11, 2013, Wells Fargo (NYSE:WFC) closed at $35.10 per share. At that time, FEB calls and puts were valued so that the following box spread could be opened:

Call spread
Buy 34 call 0.41
Sell 36 call (0.30)
Net debit 0.11
Put spread
Buy 36 put 1.45
Sell 34 put ( 0.41)
Net debit 1.04
Total debit 1.15

For $115, 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 $36 or below $34$35 per share, half of these positions will be in the money and the other half out. Between $34 and $36, all are out of the money. Each side consists 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.

Elegant? Yes, this position is promising if you look only at profit potential. But both the short call and the short put present dangers. This example involves calls above and below the money (35). A profit cushion can be built into a box spread when current price resides in between the strikes, as in this example. However, the proximity is only one factor in evaluating the box spread accurately. Of much greater concern is the exposure to short option expirations. Realistically, you are likely to close each of these legs as they become profitable. However, try to match long and short to avoid being required to put up additional margin collateral. As long as long and short are equal, margin is quite small, equal to the cost of the long options.

Traders tend to believe they will close positions when they become profitable, 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 becomes 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 $115; but this is only the initial cost. The ultimate cost including losses upon exercise could be much higher.

The box spread works beautifully on paper. In reality, risk assessment is the key to understanding why complex strategies like this do not always work out profitably.

In the virtual portfolio I manage at ThomsettOptions.com I try out many different strategies. You can see the very successful track record of numerous strategies by linking at http://tinyurl.com/aqeeops - I have not yet opened a box spread there but I may want to open one this week. I hope you will check out the portfolio, where entry positions are explained in detail, usually including a stock chart with indicated signal;s and confirmation.

Stocks: WFC