Whether you only have a few thousand dollars or a large sum to invest, the Three Legged Box Options Spread is one of the best option trading strategies available for retail investors today. You can try all kinds of strategies but according to well known veteran trader David Vallieres, this one is the best. The appealing thing about it is, that it’s execution is easy while it’s results are reliable and consistent.
We would call the three legged box spread a “lifestyle” type trade, meaning that you don’t have to keep watching the market for most of the day. It’s the type of setup which, once entered, only requires monitoring a few times each week in conjunction with setting up an alert with your broker as to when a target price in your underlying instrument has been reached.
Some Benefits of the Three Legged Box:
A high profit to loss ratio – you don’t need to get a high percentage of trades correct to make an overall profit.
Flexibility – there are many variations on how you choose to enter the trade.
Longer expiration dates – gives you plenty of time to be right and less account “churning” (turning over your money many times and paying multiple brokerage commissions).
A clearly defined loss – over hundreds of trades, the average loss is about $413 and you don’t need to place stops. Have you ever put on a trade, only to be stopped out just before it goes into profit? Three legged box options eliminate this from happening because a maximum loss is already built in – and it’s time friendly.
Defined profit targets – The average profit, based on one contract for each leg of the trade, is $1,340.
Very easy to open and close trades – no complicated spreads.
No overnight “worries” i.e. big moves or assignment.
Clear entry and exit points.
No adjustments necessary – it just works or it doesn’t.
Relaxed, informed and thoughtful trading. You just scan the markets, looking for a special set of parameters in the underlying and then place the trades.
You can trade single contracts and keep brokerage commissions low
Successful option traders know what kind of market they’re in. This is critical. With the above option trading strategies, the ideal time to place these trades is when the VIX (Volatility Index) is at 40 and coming down. At such times you have premium in the market, which provides option selling opportunities. When the VIX is below 20 these are not the most optimum strategies, (even though they’re still very effective).
But with the three legged box spread, it doesn’t matter what kind of market volatility you’re in. It could be high (VIX above 40) or low (VIX below 20) or somewhere in between – and this type of trade works just as well in any.
If you specialize in your trading style, you will make a lot more money than if you’re trying different things. This is because you’ll perfect your technique and know a lot about your strategy. The three legged box is the best one to get to know.
You have to treat this like a business and this means an expectation of a profit. Studying volatility and understanding what kind of market you’re in, or entering, increases your winning percentages of profitability. If you want to be in the top 2 percent of traders then you have to know this.
The three legged box spread has limited risk but unlimited profits to the upside.
What’s a Box Spread?
Before we can talk about a three legged box spread, we first need to understand what a regular Box Spread is. It’s a trade that has 4 option ‘legs’ at two different strike prices which, if purchased for less than the difference of the strike prices, gives you a guaranteed profit.
So let’s break down a box spread into its components, with the added feature of the delta.
Looking at the graph above, with the underlying stock currently trading at $67.50, the 55 calls would be in-the-money (ITM) while the puts would be out-of-the-money (OTM). This being the case, we can speculate that the delta on the call options would be about .89 while the puts, being OTM, would have a delta of .11. Adding the two deltas together would give us a combined delta of 1.00.
Now if we were to simultaneously purchase a 55 call and sell a 55 put under these conditions, we would create what is called a “synthetic stock position” which is another way of saying that in terms of price movement in the underlying, the unrealized profit or loss would be the same as if we had actually bought the shares. It would be much cheaper than buying the underlying stock, but would also carry the associated risk of losing more than our initial trade investment amount, in the same way as if we had “gone long” a leveraged futures, spot forex or CFD contract.
If we were to do the same thing on the 75 calls and puts, per the chart below, we would create what is called a “synthetic short stock position”. The effect would be just the same as if we had short-sold the underlying stock covered by the options contracts, instead of using options.
So by creating a regular box spread with just one contract for each leg, we achieve the same thing as if we had purchased 100 of the underlying stock at $55 and short-sold 100 shares of the same stock at $75. One counter-balances the other, but with a $20 price difference in between.
Now here’s the trick – if you can enter the 4 legs of this trade for less than the difference in strike prices including brokerage commissions, then you can forget it until option expiration date when you will make a guaranteed profit – being the net credit.
Unfortunately, it is very difficult for retail traders to put a full box spread trade on and make any money. Floor traders can do it because they don’t pay brokerage commissions and if they can buy it for less than $20 (in this case) they will make a guaranteed profit.
However, there are some retail traders who have “legged into” the box spread and done so in a retail environment, to their advantage. If your expiration dates are far enough away, giving you enough time to get the initial direction right, you can lock in profits.
The Long Three Legged Box Spread
Instead of having 4 option ‘legs’ which creates a box spread, we’re only going to have 3 legs. So taking the example we’ve been looking at above, if we remove the ITM long call option from the equation, we end up with a basic long 3 legged box spread. So we’re going to be:
- Buying a 65 call
- Selling a 65 put
- Buying a 55 put (for protection, as well as for margin reasons)
The first two above positions have effectively created a synthetic long stock position and the third position covers, or “insures” it to some degree with a protective put.
We would place the above trade if we anticipate the future price action of the underlying to rise by at least 5 percent. So in this case, it would be $67.50 x 1.05 = $70.88 (let’s say $71 to keep it simple). Notice that all the strike prices are below the current market price of $67.50.
The above “long” three legged box gives us a predefined loss on the trade, which means we don’t need any stops. It also satisfies our broker’s margin requirements because we are not over-exposed to risk.
If this stock doesn’t move, the sold $65 put will generate some theta premium for us. We essentially have a bear put credit spread alongside a long ATM call position. Let’s take a look at the profit graph at expiration.
If the stock goes nowhere, we have a maximum loss of $230. If the price action goes against us, our maximum loss will be $520. But if the price action goes in our favor (i.e. it rises) then a 5% move in the underlying will give us a target profit of $1480. If we’re lucky and see a 10% move, we realize a profit of $2960 on just one options contract.
Once in a while, we will “hit the jackpot” when a news event or similar, causes an upwards price spike. Sometimes the market will initially go against us but then will reverse and go in the direction we have anticipated. Using the 3 legged box, we give ourselves plenty of time for it to do so.
The Short Three Legged Box Spread
In this case, if we remove the OTM put options from the original box spread above, we get our short three legged box. We going to:
- Sell 70 calls
- Buy 80 calls
- Buy 70 put
It’s simply the reverse of the Long Three Legged Box spread described above.
Looking at the profit graph again, a 5% fall in the underlying will realize a profit of $1480 while a 10% downward move will rewards us with $2960. If the price of the stock goes up instead of our anticipated downward direction, our maximum loss will be $520. If it goes nowhere, we lose a maximum $230.
All the above figures are based on using only single contracts. If you traded 2 contracts per leg, you would double your profit potential as well as your potential loss levels …. and so on.
Three Legged Box Spread – Things to Keep in Mind
Before entering a three legged box spread you have to know the kind of market you’re getting into, especially the historical volatility of the underlying stock or other financial instrument. You’re looking for an underlying stock or commodity future that you believe will MOVE.
You also need to choose a financial instrument that has a liquid options market for this to work. Implied Volatility in the options can provide opportunities for variations in the strike prices you choose.
You should also never use 2x or 3x ETF’s. These are designed for day trading and can hurt you. You should also prefer stocks or ETFs that are trading in the $100 price range. This makes the 5% rule as outlined above much easier to calculate. Historically speaking, stocks in the $100 range are more likely to move the required 5% for this strategy to work effectively.
Typically, we would not hold a 3 legged box till expiration date. We choose options which have 6-9 months until expiration. This gives us plenty of time to be right.
Three Legged Box Spread Variation Example
If we can’t get a favorable P&L graph due to Implied Volatility being unfavorable, we can create a slightly skewed three legged box which converts the risk graph into something more appealing. In the end, you want to see a favorable profit & loss at expiration graph.
So experiment with strike prices and analyze.
Here’s another example of a three legged box taken on the DIA (“Diamonds”) ETF (which is based on the DOW Index). Notice the initial strike prices which are around the DIA when it’s trading at $170.50
But due to the implied volatility in the options, we might choose to buy a 165 put instead of the 170.
Here are some examples of stocks and ETFs that trade on the US markets that work well with the 3 legged box spread: