Low-Cost Leverage: The “Box Spread” Trade

December 9, 2021, major revisions on October 2025, 2023 – Last month, I published Part 49 of my Safe Withdrawal Rate Series, dealing with leverage in retirement. In that post, I surmised that the cheapest form of leverage likely comes in the form of a margin loan in an Interactive Brokers (IB) account. If you have the IB Pro account, you can access loan rates tied to the Federal Funds Rate plus a tiered spread ranging from 0.3% to 1.5%. Though, the really low rates don’t start until your loan reaches at least $3,000,000. For more manageable loan amounts that the average retail investor would use, we’re looking at a higher spread: 1.50% spread for the first $100,000 and 1.00% over the Fed Funds Rate for the next $900k. That’s a very competitive rate. Certainly better than a Home Equity Line Of Credit (HELOC), which is usually at around Fed Funds Rate plus 3%.

In the comments section, though, a reader brought up an idea for an even lower-cost method for borrowing against your assets: an exotic options trade called a “box spread”. Since writing this post in 2021, I’ve utilized the box spread loan. So, in today’s post, I would like to go through the basics of the Box Spread, how to implement it, and how this trade could in fact give us a cheaper form of leverage than even the rock-bottom rates from IB. Let’s take a look at the details…

Box Spread Basics

A Box Spread involves four options trades, two long and two short option positions at two separate strikes. It can be designed to mimic a loan where we achieve a positive cash flow today and pay back the “loan” on the expiration date. Specifically:

• Pick two strikes X1, X2, with X1 smaller than X2
• Sell one Call with strike X1
• Buy one Call with strike X2
• Sell one Put with strike X2
• Buy one Put with strike X1
• All four options have the same expiration date.
• All four options must be European Options, i.e., they are exercised only at the expiration, not before. This will eliminate single-name stock options because they are normally American-style with the option to exercise.
• I’ve been told that this should only be done if you use “Portfolio Margin.” Not recommended for Reg-T. This trade is not allowed in cash accounts or IRAs.

One can now quickly confirm that the payout from this trade at expiration is precisely the spread between the strikes X2-X1, no matter where the underlying U ends up on the expiration date:

• If U<X1 then the two calls expire worthless but the puts are both in the money. We pay out X2-U on the short put and we receive X1-U on the long put. Profit = X1-U-(X2-U) = -(X2-X1), i.e., we pay out X2-X1
• If U>X2 then the two puts expire worthless but the calls are both in the money. We pay out U-X1 on the short call and receive U-X2 from the long call. Profit = U-X1-(U-X2) = -(X2-X1), i.e., we again pay out X2-X1
• If X1≤U≤X2, i.e., the underlying finishes between the two strikes then the short Call and the short Put are in-the-money while the long options expire worthless. On the short Call we have to pay out U-X1 and on the short Put we pay X2-U, for a total loss of X2-U+U-X1=X2-X1.

Because we have established a payoff of precisely -(X2-X1) regardless of the final underlying, we have issued a synthetic zero-coupon bond for which we pay out X2-X1 (times the multiplier of the option, of course). So, for example, I issued a box spread trade on the S&P 500 index with a 12/17/2026 expiration. The two strikes are X1=4400 and X2=4600. The multiplier is 100x. and the synthetic zero-coupon bond would have a notional of $20,000.

If I have to pay back 100x$200=$20k in 2026, how much money did I get earlier this week on 12/6/2021? Well, financial markets are supposed to be efficient, so this implicit 5-year loan should trade at an implicit loan rate of roughly “the risk-free rate” over that time span. I put that phrase in quotation marks because there isn’t one single, generally accepted risk-free rate concept over a five-year horizon. But more on that later. Before that, I like to go through the different steps to initiate that trade on the IB trading platform…

Implementing a Box Spread in an Interactive Brokers Account: A step-by-step guide

Update 10/25/2023: A previous version of this post went through a long list of steps utilizing the “Spread Trader” feature in Interactive Brokers. I found a faster and easier way using the “Strategy Builder” function.

Because four separate options are involved, keeping the trading costs and bid/ask spreads to a minimum is crucial. It would be prohibitively costly to initiate four separate trades for the four legs due to the large bid-ask spreads. But don’t despair… Interactive Brokers to the rescue! IB offers the Spread Trader and a Strategy Builder functions where you can send packaged orders that give you simultaneous(!) trades for all four trades and only one single bid-ask spread. You still have to pay commissions for all four options, but that’s a drop in the bucket!

Here’s my step-by-step guide for the Strategy Builder route:

In the IB desktop app, click the menu “Trading Tools” and select the “Strategy Builder” feature.

This opens a new window, where we enter “SPX INDEX” in the top left field. I set the field next to it to “PUT/CALLs (Side by Side),” please see below:

Next, we pick the expiration date equal to the maturity date of our box trade loan. If your date is not already listed in the top menu, we click “MORE” to bring up a list of all possible options expiration dates. Let’s assume we like to borrow until December 19, 2024. I’m writing this on October 25, 2023), so this is a loan for a little more than a year:

Imagine we like to borrow $50,000, so we need to use a 500-point spread because each SPX option has a multiplier of 100x, so a 500-point spread constitutes a 500x$100=$50,000 box loan.

With the S&P 500 around 4200 points, I pick a box spread that roughly straddles today’s index value, so we pick the 4000-4500 box. This is not a requirement. You may also use a 5000-5500 box spread or a 3000-3500. However, I noticed that the boxes closer to today’s index values have higher chances of getting your limit order filled. Once we click the date, we see the list of puts and calls expiring on Dec 19, 2024. I click the “Bid” field at the 4000 Call and the “Ask” field at the 4500 Call. And then the Bid field at the 4500 Put and the Ask field at the 4000 Put. Lo and behold, this populates the 4 legs of this strategy below: we sell the 4000-C, buy the 4500-C, sell the 4500-P, and buy the 4000-P. IB is smart enough and recognizes this as the “Dec19 ’24 4500-4000 Box.”

We can already trade out of this window, but normally, I like to copy this spread into my watchlist. Click “+Add to Watchlist” to do so. In the screenshot below is the line item with this 4500-4000 Box. If you like, you can also enter some other $50k box spreads, like the 4000-3500 spread or 4250-3750, but to keep it simple, I only present this one box on this watchlist. On my actual watchlist, I’d have many more lines with different expiration dates, all the way to December 2028, and also different loan sizes, e.g., $20k, $50k, and $100k.

First of all, notice that the price on this box trade is negative; see the Bid at -473.70 and the Ask at -465.20. Notice how massive the bid/ask spread is. You never want to enter a market order! Only a carefully calibrated limit order! More on that later.

So, how do we enter a limit order from here? Just like we always do in IB. To borrow money with this box, we’d need to buy this box at a negative price to get a credit into our cash balance. For example, if I wanted to buy this box for -470, I’d enter a limit order at -470. We can also quickly double-check by right-clicking the order and selecting “Check Margin/Performance Profile,” which opens the following “Order Preview” window.

All looks good: the 4 legs of the box are as we want them. The order would be worth -47,000, meaning it’s a credit (note the green “C” sign). After a commission of about $6, we’d get a credit of $46,994.52 to the cash balance. This order would be ready to transmit. As mentioned above, you must carefully target a suitable limit price because the B/A spreads are usually quite wide. This brings me to the next section…

What price (and implicit interest rate) should we target?

The -470 limit was just a dummy price I used for illustration. How do we pick an appropriate price? First, let’s consult Bloomberg to see what today’s market interest rates are; see below.

For December 2024, 14 months years from we’re a bit past the 5.44% yield for the 12m Treasury. There is a rapid drop between 1 and 2 years, so a 14-month Treasury should fetch about 5.40%. We can consult Excel and see how different prices for this box will change the IRR of your box loan. For example, getting a $47,000 credit on 10/25/2023 and paying back $50,000 on 12/19/2024 gives you an IRR of 5.51%.

It’s unlikely that you’ll be able to borrow at only 11bps above Treasury rates, so you may have to increase the price a little bit, i.e., make it less negative, say -469.50. This would raise the IRR (=your loan interest rate) to 5.61%.

I gathered on the interwebs that a spread of around 20-30bps (0.20-0.30%) seems appropriate. A useful tool for calibrating the target interest rate is the site www.boxtrades.com (thanks to reader Matt for bringing this to my attention), where you can see the log of past trades for SPX box spreads.

Why is there a spread in the first place? Well, your counterparty, the lender in this context, would consider the loan not 100% free from default risk. Exchange-traded derivatives are extremely safe against default. Even if a counterparty cannot pay, the clearinghouse would guarantee the transactions. So, you still have the possibility of a clearinghouse going belly-up, but that’s extremely unlikely. But we must still add a small spread on top of the Treasury yield to account for that unlikely event.

Even with the spread above the Treasury rate, you’d get a loan with a much better rate than even the competitive IB margin rate.

Update 2/2/2022: The Finance Buff posted a similar article with the step-by-step process you can use at Fidelity.

Update (12/9/2021 9:30PM): How will this impact your margin?

Since people asked in the comments section: how will this impact my account margin? Let’s go through an example. Someone has $100,000 invested in stocks (or ETFs), $0 in cash, and gets a box spread “loan” which deposits $20,000 into the account. If the money is just sitting in cash, nothing happens to your margin. Your net account value is still the same (abstracting from the $5 in commissions, for simplicity). See below:

Nothing really happens to your margin picture. You have a $100k account and you need to keep a minimum of $25k to keep your $100k in margin. That’s because the margin requirement for Portfolio Margin accounts in IB is 25% for stocks and ETFs. Of course, if your stocks go down by 50% then your margin cushion shrinks. But the same would have happened without the box spread trade.

But of course, nobody would ever just issue a box spread “loan” and leave the money just sitting there unused. More likely would be one of the two situations: take the $20k and buy more stocks or withdraw the $20k and use them for something else (living expenses, down payment for a house, etc.). Or a combination of the two. Let’s simulate that in the table below. The top panel is for the box spread. The bottom panel is for the regular margin loan. The left side is for a $20k investment in stocks, the right side is for the $20k withdrawal.

Absolutely, if you either buy more shares or withdraw the money it will shrink your margin cushion. If the market then tanks, it will worsen the situation. Also notice that from a margin perspective, the box spread loan and the margin loan are the same.

Update 12/15/2021: What about the “Payments in lieu of Dividends” issue?

When you buy assets on margin you will likely lose some of the tax advantages of the assets you buy. Dividend income will then be reclassified as “Payment in Lieu of Dividends,” which will be taxed as ordinary income. That could pose a significant tax drag if qualified dividends, taxed at the same lower rate as long-term dividends, are now taxed like ordinary income. For us, this would raise the marginal tax rate from 15% to 22%. Even worse, municipal bond interest from our closed-end funds (such as NVG, NZF, NMZ) would go from tax-free to a 22% marginal tax. Ouch!

It’s not clear how the broker will treat the box spread loan. You still have a positive cash position, but it’s not entirely clear if IB will factor the large short option position into the cash value. So far, so good though. I received a large dividend payment today on December 15 and it was all treated as “ordinary dividends”. Nothing was classified as the dreaded “payment in lieu of dividends.” Granted, most of the dividends were announced in November with a record date in late November when I didn’t even have any box spread loans. But one preferred share had a record date on December 13, after I initiated the box spread. Even that one is still listed as an ordinary dividend! I hope it stays this way for future dividends!

Conclusion

Thanks to my reader “TIM H” who reminded me of this useful tool. In today’s post, I just wanted to give an update on what I learned and share my notes with you. A box spread is a neat tool to generate margin loans at rock-bottom rates. Here are the pros, but I also like to point out some cons.

Pros:

• With a box spread trade we can likely generate margin loans with a rate even lower than the already competitive IB rates.
• While you can indeed write off margin interest, most people will not be able to do so effectively because you’d need to use itemized deducttions. With the massive standard deduction of almost $26k in 2022 (married filing jointly), you’d need a really large margin loan to get over that and/or a lot of other itemized deductions. And then, only the amount above the standard deduction is effectively useful as a deduction. On the other hand, the implicit interest you pay on the box spread loan is indeed fully tax deductible. The SPX options are Section 1256 contracts and the losses will be considered 60% long-term and 40% short-term. I generate substantial option trading profits with my put-selling and the margin loan costs will offset some of those gains. Even in the absense of any other capital gains you can write off up to $3,000 in capital losses annually against your ordinary income.
• You can lock in a fixed interest rate over a specific time horizon.
• The “loan” cannot be called. Unlike a margin loan, where your broker could just willy-nilly pull the rug from under you, the box spread is a fixed-term loan. Non-negotiable. If you use European-Style options like the CBOE SPX contracts I use. Never do this with American-style options on individual stocks or ETFs!

Cons:

• While the lock-in of the box spread implicit interest rate might be plus it can also be a headache. If the future path of the Fed Funds Rate is much lower than expected today, say due to another pandemic shutdown and recession, you might do better with the “variable” loan tied to the FFR. In today’s landscape, though, that’s hard to imagine because even if the Fed Funds Rate stayed at 0% for the entire 5-year period, you’d still pay 1.50%, not much lower than my box spread loan. But The Fed will have no choice but to raise rates in 2022 and 2023 due to the post-pandemic inflation shock.
• Box Spreads are more cumbersome than simply drawing down a margin loan. It’s not for the faint-hearted! It involves some serious derivatives trading. In the example above, you trade four options with a total notional exposure of $100x(4400+4400+4600+4600) = $1,800,000. And all that get a $18,400 loan. But look at the upside: you can really impress people at your next cocktail party.
• No room for error! Make sure you add the “-” sign in the limit order. A tiny fat-finger mistake and you might be out of a five-figure sum!
• You’d need to file an additional tax form , if you don’t already trade Section 1256 contracts: IRS form 6781. But that’s not much of a burden. The neat thing about Section 1256 contracts is that you don’t have to itemize any of your trades. Just plug in one number, the net profts of your Section 1256 contract for that entire year and you’re good to go.

Postscripts

PS1: Some purists might point out that the truly cheapest possible leverage would be to liquidate your stock and bond positions and then simply go long S&P and Treasury futures to keep the same stock and bond exposure as before. Keep the cash in short-term funds, like a money market fund or 3-Month T-Bills. And then slowly deplete that cash until you do the next swap of physical assets into cash + futures. You can now effectively “borrow” against your assets at the short-term risk-free rate because futures are indeed priced to replicate the return of the underlying minus the risk-free asset return.

The advantage of this approach is that you might get the lowest possible “interest rate” but you also liquidate your assets over time with all the tax consequences. So, the estate planning option of letting the capital gains run until you can pass the asset on to your heirs and they get the step-up basis goes out the window. But if you don’t care about that and/or you reside in the 0% capital gains bracket anyway, this might be something to consider.

Update 12/11/2021: Well, not so fast. It turns out that with a long futures contract you don’t get to borrow at exactly the risk-free rate either, but more likely at a rate risk-free plus about 0.3%-0.4% as folks pointed out in the comments section. If you factor in the 1.3% expected Fed Funds rate over the next 5 years and you add 30-40bps to that you end up right at the box spread implicit interest rate. There’s no free lunch.

PS2: Another route suggested by a reader would be to buy a leveraged ETF. Say, for example, you need $50k to live on, then you’d sell $100k worth of assets and invest the remaining $50k in a 2x leveraged ETF.

Not recommended! I looked at the returns of the three funds: IVV (S&P 500 index fund, i.e., 1x). SSO (S&P 500 2x) and SPXL (S&P 500 3x). Via Portfolio Visualizer, I got total return data for all three funds going back to 12/2008. Annualized standard deviations indeed scale just as expected. The leveraged ETFs have pretty much exactly 2x and 3x the standard deviation of the index fund, respectively. But the realized returns? Not so much! If I calculate the implied CAGR as

Implied CAGR = Risk-Free + Leverage * (S&P500 – Risk-Free)

…, i.e., what the theoretical futures non-arbitrage condition would imply, then the actual leveraged ETF returns lag behind that “theoretical number” very significantly. By 4% and 10% for the 2x and 3x leverage funds, respectively.

Only a small part of this can be attributed to the expense ratios. The 2x and 3x funds are also subject to a lot of trading (churning?) and the dreaded “whipsaw risk” because every day the portfolio managers have to rebalance the futures positons to exactly match the target leverage. So, leveraged funds seem far too expensive when considering all the costs, not just the expense ratios! Not just in this context, but more broadly as well, I would stay away from leveraged funds!

Thanks for stopping by today! Please leave your comments and suggestions in the section below! If you have traded box spreads before, please share your experience!