Box Spread Arbitrage Option Strategy Explained

Despite being a largely technical strategy, Darvas box theory as originally conceived did mix in some fundamental analysis to determine what stocks to target. Darvas believed his method worked best when applied to industries with the greatest potential to excite investors and consumers with revolutionary products. He also preferred companies that had shown strong earnings over time, particularly if the market overall was choppy. It is an alternative to buying a long put because selling a low-priced put at strike price A compensates for the cost of the put if you purchased it at strike price B.

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Darvas applied his strategy when the flow of information was much slower, and technical charting was impossible. The same principles Darvas used could be applied with technical charting. box trading strategy This debacle was posted online including on various subreddits, where it has become a cautionary tale (especially after said trader boasted that it was a virtually riskless strategy).

The top half of the table tests exchange traded funds and the bottom half tests a portfolio of stocks. The only parameter varied is
the time required for a new high to appear. When price rises to a new high in October, it signals a buy, which I show in blue. The actual purchase would be made at the market open the next day. Since price has made a new high,
the search for a box top would begin and be found a few days later. I raised the peak on the black box to show a new high (that is, I lengthened the black candle on the first box top in October).

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The market environment is now ripe with significant financial gains for traders who place large counterparties. The Darvas Box Theory is applied today through technical analysis. Technical analysis utilizes boxes or other technical tools that follow underlying principles, such as support, resistance bands, and momentum.

When the option’s predetermined price surpasses the prevailing market price and one has to pay a premium, then it is an ITM. In contrast, if the option’s prevailing market price is higher than the strike price, and no intrinsic value is involved, it is said to be an OTM. Notice that this small but positive for all possible expiry prices meaning that the spread is risk free; it’s an example of an arbitrage trade. Another limitation is the risk of false breakouts, where the price breaks the box’s top, prompting a buy, but then quickly reverses and falls back within the box or even lower. The upper boundary, or box top, is defined by the stock’s high price that isn’t breached for three consecutive days or more. Conversely, the lower boundary, or box bottom, is determined by a low price that isn’t violated for three consecutive days or more.

Box Spread Example 1

That test results in inferior results for the reasons I mentioned. I mentioned above that this occurs about 39% of the time, but allowing a lower stop seems to improve results to a minor degree. The hold time loss is how far price drops below the buy price during the trade, averaged over all trades.

Please keep in mind that the breakouts shown were not backed up by a volume study. The results could be different if there was a measurement made of the strength of the breakout. Download our Desktop terminal and Mobile app Desktop terminal and Mobile app to stay on top of the FNO markets. Let’s say you were able to ride VCNX up and you also were adding to your position as the stock went in your direction. Notice how the blue box identifies a new high, the consolidation, and the subsequent breakout levels. Darvas’s rules were fairly simple, as stated in his book How I Made $2,000,000 in the Stock Market.

Now let’s review the hard part of the system, which requires tremendous discipline — the ability to not only pick the right stock but to also understand when market conditions are ripe. For example, Darvas clearly says buy the new 52-week high, so the look-back period is honestly irrelevant. Do what feels right to you, but we would recommend you stick as close as possible to Darvas’s original intent to see what part of the strategy works for your trading style. Darvas used three bars consolidating under the first high bar to construct the box. However, you can now configure the boxes to your liking with a few clicks of the mouse.

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This is because you will find yourself buying the breakout and then consequently selling the breakdown at the bottom of the box. To construct a box spread, a trader buys an in-the-money (ITM) call, sells an out-of-the-money(OTM) call, buys an ITM put, and sells an OTM put. In other words, buy an ITM call and put and then sell an OTM call and put. Box spread trading requires ample market knowledge to anticipate market momentum. Hence, it is generally suited for seasoned traders with market trade experience. We will discuss what box trading strategy is, how it works and its benefits and risks.

In options trading, a box spread is a combination of positions that has a certain (i.e., riskless) payoff, considered to be simply “delta neutral interest rate position”. Implied volatility has no direct impact on the profitability of the long box spread strategy. Because the position looks to take advantage of arbitrage and has opposing debit spreads, it does not capitalize on an increase or decrease in implied volatility. However, volatility may affect the pricing inefficiencies when the long box spread is entered and/or assist with potentially selling the position for more premium than the width of the spread. Because the strategy consists of two debit spreads, it will cost money to enter. The goal is to purchase the long box spread for less money than the width of the spreads.

Limitations of the Darvas Box Theory

The trader avoids losses, but this risk reduction comes at a cost because they must forfeit some profits. In practise, the Darvas box theory is designed to help investors have performance that surpass the overall market performance. This theory is based on monitoring the growth of an industry by using the performance of selected stocks, their market prices and trading trends overtime.

• The goal of a long box spread is to exploit an arbitrage situation based on the mispricing of option spreads.
• If the strategy costs the amount of the spreads or more, it does not make sense to enter into a long box spread.
• Nicolas Darvas is a famous trader who made 2 million dollars trading the stocks market.
• With enough market knowledge and cost-benefit analysis, one can ensure that the profit is almost guaranteed regardless of the market conditions.

Although the potential rewards from a box spread trading strategy are relatively low, the probability of making a profit is high. During the depression, the bond and credit markets stiffen, causing economic instability. But, at the start of the recovery, interest rates start to dip very low as market forces work to bring the economy back up to equilibrium. At this time, trading and, consequently, market volatility starts to resume, and this is the time to enter into a long position.

Can I use box spread trading for Nifty 50?

Darvas box theory is a trading strategy developed by Nicolas Darvas that targets stocks using highs and volume as key indicators. Yes, a box spread trading strategy can be implemented on any equity derivative including indices like Nifty 50. So let us assume that an XYZ share has a current market price of ₹25 per share with a lot size of 100. As stated before, traders simultaneously execute 4 options contracts at the same time which are as follows.

To ensure that the pricing will be stable at the time of entry, the four legs of a long box spread must be purchased simultaneously. However, this is very difficult to execute at arbitrage with the current efficiency of markets. For example, if a stock is trading at $50, a $45 call is purchased and a $55 call is sold. The Darvas Box Theory was a trading strategy that was invented by self-taught investor Nicolas Darvas, who used to target stocks with pricing and volume as indicators. However, it also has  several disadvantages, like high commissions, minimal profits, interest rate risks, etc.

It requires a certain amount of payoff to create a neutral interest rate position in the market. The theory gave insight on when to enter and exit certain positions by drawing boxes around the highs and lows over time. It instructs practitioners to only take long positions in rising boxes and use the highs of those boxes to set exit points. So that if a stock price fell below that exit point, the stock should be sold.

To execute the box spread, a trader buys a bull and bear spread with identical strike prices and expiry dates. The box is purchased at a lower price than the combined value of the spreads upon expiry, so the trader locks in a profit fairly easily. By combining both a bull call spread and a bear put spread, the trader eliminates the unknown, namely where the underlying asset closes at expiration. This is so because the payoff is always going to be the difference between the two strike prices at expiration. The long call spread strategy is an alternative to buying a long call because selling at a higher strike price, B, offsets the lower cost paid for it.

Something about the proximity to Wall Street and the instant availability of information made him overtrade and over think. For that reason, he went back to his “detached” style of trading while on the road and found success again. It was this intuition on up-and-coming companies that benefitted Darvas greatly. He was a master of “social arbitrage,” before that was even a term. Yet, his strategy for entering the market was so simple that he could enter orders from anywhere in the world his dancing profession took him. Box spreads are typically used in situations where the market is volatile.