long-term capital losses and 40 % shortterm capital losses, regardless of the holding period of the box spread.
An added advantage of the strategy is that for every year the box spread is in place, most of the extra expense can be deducted as a capital loss— which is a huge tax benefit for clients facing sizable capital gains taxes.
“ Institutions have been using box spreads for decades,” says Bryan Sapp, a chartered financial analyst and portfolio manager at Exceed Investments, a specialized options shop in New York.“ Few advisors realize that options can very effectively replicate loan economics and benefit their clients.”
Still, these loans aren’ t for the timid. Before embarking on this strategy, investors must find an options shop they trust.
How it Works
The four options contracts, or“ legs” of the arrangement, are said to define a box spread.
On the client’ s behalf, an options trader sets up two sets of opposing options contracts on the same asset, usually an index like the S & P 500. If the S & P 500’ s current level is 6,000, say, we’ ll call it $ 6,000.
The first pair of options create a long position on the index. For one leg, the client pays an up-front premium of, say, $ 180 a share to buy a call option on the index at a preset strike price of, say, $ 8,000; this allows the client to buy the index at that price on the expiration date.( For box spreads, options contracts cannot be exercised before the expiration date.)
On the expiration date, if the index value remains lower than the strike price, the option simply expires. But if it’ s higher than the strike price— say, $ 9,000— the client comes away with a bargain: $ 1,000, which is the difference between the index value on that date and the strike price.
Because options contracts have an automatic multiplier of 100, this actually represents a $ 100,000 gain. And all that’ s lost is the $ 180 per share premium( which is really an $ 18,000 net loss).
For the second leg, the client simultaneously sells a put for the same index at the same strike price and with the same expiration date, pocketing a premium of, say, $ 1,450 per share. In this case, if the index is higher than the strike price at expiration, the put expires. But if it remains below the $ 8,000 strike price on that date— say, $ 4,000— the client is obligated to sell it for the $ 8,000 strike price( allowing somebody else to buy it at that price on that date). The result is a net loss of $ 400,000($ 4,000- $ 8,000) x 100.
Factoring in the premiums paid for the first leg and received in the second, there is also a gain of $ 163,000($ 145,000- $ 18,000).
The third and fourth legs of the strategy create a short position on the same index— selling a call option on it, for which the client receives a premium of, say, $ 1,480 per share, and simultaneously buying a put option on it, which costs the client a premium of, say, $ 220 per share. Both of these options contracts have the same expiration date as the long position, but at a lower strike price, say $ 5,000.
From these two transactions, the client pockets an up-front net premium of $ 126,000 per share, which is($ 1,480- $ 220) x 100. Taking all four legs together, however, the total premiums come to a net gain of $ 289,000($ 163,000 + $ 126,000).
That’ s at the start. But on the expiration date, if the index value remains above the $ 5,000 strike price— say it rises to $ 9,000— the client must use the call option and sell the index for $ 5,000, incurring a deficit of $ 400,000, which is the difference between the index value at expiration and the strike price($ 5,000- $ 9,000) x 100.
On the other hand, if the index falls below the strike price at expiration— say it lands at $ 4,000— the client exercises the put option, selling the index for $ 5,000. This would yield $ 100,000, the difference between the strike price and the index value at expiration($ 5,000- $ 4,000) x 100.
Either way, the short position means the client will sell the index on the expiration date, no matter where the index value ends up.
Altogether, on the day that all four options expire, if the index rises above the higher strike price both call options will be exercised. The net result is a loss of $ 300,000($ 100,000- $ 400,000), notwithstanding the premiums. If the index value at expiration drops below the lower strike price, both put options will be used, resulting in a loss of $ 300,000($ 100,000- $ 400,000). In other words, wherever the index ends up at the expiration date, the result is the same: The client will buy the index at the higher strike price and sell it at the lower one, leaving a net loss equal to the difference between the two strike prices.
Don’ t forget, though, that the client also received a gain of $ 289,000 from up-front premiums. No matter which way the index moves, the client starts with a net premium of $ 289,000 in hand and must pay out $ 300,000 when the options expire. That $ 289,000 can be used by the client for any purpose. It doesn’ t have to go to a large onetime purchase; it could, for instance, be used as a short-term cash substitute. The amounts are guaranteed by the options contracts.
Even if the underlying asset— the S & P 500, in this example— falls into bear market territory, the results would be the same. The payout and amount due are fixed from the outset.( Note that the borrower must have enough assets in their brokerage account to hold as collateral against the loan amount.)
The net cost of this“ loan” is roughly $ 11,000($ 300,000- $ 289,000)—“ roughly” because small transaction fees may be added in. That $ 11,000 is 3.81 % of the amount received, making this the equivalent of a $ 289,000 loan due in full on expiration with a 3.81 % interest rate.
Of course, the numbers in this example are entirely fictitious. Specialized box-spread providers can plug in more realistic numbers to meet clients’ needs, as well as handle the complexity of these synthetic loans.
The box-spread is attractive because it allows all the other exposures other than the interest rate to be hedged away.
“ The box-spread structure is specifically designed to be market neutral,” says Karan Sood, CEO and co-founder of Vest Financial, the McLean, Va.-based asset manager and fintech company. The firm’ s Synthetic Borrow software platform helps advisors carry out box spreads.“ A box spread that’ s based on the S & P 500, for example, doesn’ t depend on the S & P 500 going up, down or sideways. The box’ s four legs are designed to offset each other’ s market exposure com-
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