|Back to main|
An Important Word of Caution on Short Box-Spread Trades!
12/10/2010 2:20:00 PM
By: Steve Claussen
Some things we learned as children:
"There is no such thing as free money."
"If you see something that looks too good to be true (especially in options trading), it probably is!"
"A little intelligence is a dangerous thing."
I am compelled to warn readers about a trap I have seen too many option traders fall into. That trap is selling "boxes" on stocks for more than the difference between strike prices. (A box is a 4-legged trade where you sell one combo and buy another combo.) Theoretically, they may think, it cannot be worth more than that difference. This is most definitely NOT TRUE. They are forgetting about Dividends!
For example, I have recently seen traders looking at the options in the SPDR S&P 500 ETF (SPY). The 120-125 box for instance. In this example, the 120 calls would be sold, the 120 puts bought, and the 125 calls are bought while the 125 puts are sold.
Here are the current markets in those four options:
120 Calls 4.05 | 4.07
120 Puts 0.20 | 0.21
125 Calls 0.46 | 0.47
125 Puts 2.03 | 2.04
Crossing all four bid/ask spreads, the total bid price for the box comes to $5.40. If there was no dividend, the most this could be worth would be $5 at expiration. Seems riskless and it seems like a free 40 cents! Too good to be true, right? NO WAY! The market is not in business to give away money.
The SPY goes ex-dividend on Friday, December 17 with an estimated dividend of $0.65. The day prior to the ex-dividend date, long in-the-money call holders will early exercise their options – the December 120 calls in this case, to have a long stock position before the ex-date. Most short contracts in the 120 calls will be assigned, causing those portfolios to become short stock and they will owe the 65-cent dividend to the long holders. This will likely cause this $5.40 sale to ultimately be a $4.75 cent sale and result in a loss of 25 cents. The actual settlement value of this box is $5.65 --- $5 for the difference between strikes plus the 0.65 for the dividend.
Even if you buy back the short stock first thing on Friday morning, it is too late! The damage is done. You are short stock prior to the ex-dividend date and you owe it plain and simple.
Don’t fall into this trap! This potentially occurs with all dividend-paying stocks and also affects in-the-money call spreads as well.
Another adage to remember … “Being forewarned is forearmed!”