April 17, 2024 – People sometimes ask me for a good and safe place to “park” their money for a short period. CDs, high-yield savings, and money market accounts would be the obvious answers. When looking for safe, short-term investments, options are probably the last thing on your mind. Options have the aura of complicated and highly speculative investments. However, sophisticated investors can structure options trades to make them (almost) as safe as CDs but with more flexibility and higher after-tax income, thanks to a Box Spread trade.
You can implement this trade by hand, and I will go through the mechanics. You can also buy an ETF, though with some small drawbacks. Let’s take a look…
Avid readers of the ERN blog will know that today’s post is an extension of an older post where I proposed box spreads to borrow against your portfolio. But we can certainly reverse the box trade and use it to lend instead of borrow funds. So, let me explain again what a box spread is and how you can trade one at Interactive Brokers, a site I heavily use for all my options trading needs.
What is a Box Spread?
As I detailed in my post from a while ago, a box spread consists of four options positions at two separate strikes: two puts and two calls. At each strike, there is one put and one call. Because the payoff profile of this set of four options is strictly a straight line, equal to the spread between the two strikes, we’ve essentially constructed a synthetic zero coupon bond that pays off a fixed amount regardless of the underlying at the time of expiration.
Here’s a concrete example: We buy the S&P 500 index Call with a 4000 strike and the Put with a 5000 strike. And also sell the 5000 Call and the 4000 Put. In the chart below, I display the P&L from the four underlying positions as well as the total: The four lines always add up to 1000 points no matter where the index lands on the expiration date.
In this example, it might be easier to see the mechanics of the box spread when displaying the same numbers in a table:
- If the underlying is below 4000, the calls expire worthless, and we receive the put spread of 1000.
- If the underlying is above 5000, the puts expire worthless, and we receive the call spread of 1000.
- Between 4000 and 5000 points, the short call and short put expire worthless, while the payoffs from the two long options exactly sum to 1000.
Also, notice that the spread is quoted in index points, while the CBOE index options each have a multiplier of 100x, so the total payout in December is $100,000.
Warning: You should only do box trades with “European Options,” e.g., CBOE SPX options, futures options, etc., that cannot be executed before expiration. Never do a box trade with “American Options,” e.g., options on individual U.S. stocks! Early execution of one of the short option legs before expiration would destroy the constant P&L line in the chart above! People who are confused about the difference between European and American options can lose a lot of money.
How do we trade this combination of four options? Do we enter four separate market orders for the four different legs? Better not! You’ll likely encounter large bid/ask spreads, especially for the deep-in-the-money options. Interactive Brokers offers a combination trade that’s much more efficient, ensuring tighter spreads and that all four legs trade simultaneously.
Here’s the implementation in detail:
Box Spread trading at Interactive Brokers: A step-by-step guide
1: Start a new watchlist and click the menu. Under Trading Tools, click “Strategy Builder:”
2: This opens a new window. In the field at the top left, I use “SPX index” and make sure to keep the other pulldown menu at “PUT/CALLs (Side by Side).”
3: The first four expirations only go to July 18, 2024. But when I click on “MORE,” I can find the December 19, 2024 expiration in the pulldown many. Click that:
4: This brings up the entire list of strikes in the middle column. Calls are on the left, and Puts are on the right. Imagine we like to generate a 1000-point spread (for a $100,000 payout). Let’s look for between 4000 to 5000 points. I click the ASK price for the 4000 Call, the Bid Price for the 4000 Put, the BID price for the 5000 Call, and the ASK price for the 5000 Put. Each click generates a “leg” of this strategy, and we end up with the four legs listed at the bottom of the window. IB is smart enough to recognize this combination as the “DEC19 4000-5000 Box,” which is a great error check. We can also quickly confirm that this 1000-point payoff costs you about Bid=962.50 to Ask=967.30 points. So, the $100k, effective zero-coupon bond would cost us about $96,500 if we can buy this spread at around the midpoint. That means we’d spend $96,500 today to receive $100,000 in December, i.e., a guaranteed gain of $3,500.
We can click “Add to watchlist” at the bottom to export this to our Box watchlist. We should also iterate this process a few times and add a few more 1000-point spreads. Click “Clear all legs” and populate a new 1000-point spread, like 4500-5500 and 5000-6000. I recommend using strikes close to the current SPX level and round strikes. There is probably very little activity in the 6400-7400 or 1000-2000 box spreads!
5: On that watchlist, we can now track the quotes of the three spreads. The best bid was 962.5 for the 4000-5000 spread, and the best ask was 963.30 again in the 4000-5000 spread. I took this screenshot around noon PDT on 4/16.
6: I right-click on the 4000-5000 spread and click “Buy” (=lend) this box spread and set the price to the midpoint of 962.90. I can also right-click the order line and select “Check Margin/Performance Profile” to perform one last error check; see the screenshot below. This trade triggers a $96,290 debit, and the commission is around $6. I can double-check the four underlying legs again and that the trade does not impact my margin constraints (except for the small commission).
I didn’t submit the buy order in this case because I already have several long box spreads expiring on 12/19/2024, but this is how I’ve previously entered my trades.
How much money can I earn with a Box Spread?
In the example above, trading the 12/19/2024 box spread on 4/15/2024, let’s look at what kind of implicit interest rate I would have earned. Let’s take the best bid and ask prices as well as the midpoint of 964.10 to gauge how different prices would yield different IRRs. I use the quotes 962.50 (highest bid), 963.30 (lowest ask), as well as the midpoint of 962.90 and a commission of $6.00. We’d have to spend between $96,256 and $96,336 to guarantee a future $100,000 payout. That translates into an IRR between 5.65% and 5.78%. You could get the 5.65% immediately if you buy at the ask, but chances are that you may get a better yield if you’re patient and put in your bid at the midpoint.
What is a good price to fill this order? My experience is that you target the risk-free Treasury yield of the same duration plus about a spread of 0.30-0.40 percentage points. So, with the 1-year Treasury yield at 5.17% on that day and the 6-month T-Bill at 5.36%, interpolate that to maybe 5.30% for the 8-month yield, plus 0.35%-0.40%, and you get right to 5.65%. So, even at the ask price, that’s a very competitive yield, but you may get a fill at a slightly lower price and higher yield as well, maybe even the midpoint.
In any case, why all this effort for 5.7%? Why not just get a CD? Fidelity offered CDs at around 5.25%-5.35% on the same day for 6mo and 9mo CDs, respectively:
You might get 5.50% or even 5.70% by shopping around. Why all this hubbub for just a few basis points of extra yield? This brings me to the next point.
The Box Spread Tax Advantage
Gains from SPX index options enjoy preferential treatment on your tax return. Even though you hold your December Box Spread for only about eight months, the gains are treated as Section 1256 income, taxed as 60% long-term and 40% short-term gains – reported on IRS form 6781 – regardless of the holding period. So, let’s look at how the three different box spread IRRs translate into after-tax rates of returns and how those returns compare to CDs, where your income is subject to the ordinary income tax rate. In the table below, I calculate the after-tax return of the box spreads in four different tax regimes:
- A low-tax regime, where our investor is in the 0% tax bracket for long-term gains and 12% for ordinary income. This would apply to early retirees with an annual income below about $123,000. For example, married couples filing jointly: $29,200 standard deduction plus the top of the 12% bracket $94,300 = $123,500. Or $123,250 when using the top of the 0% long-term capital gains bracket.
- In an intermediate tax regime, you’re in the next tax bracket and pay 15% and 22% for long-term gains and ordinary income, respectively. This could be a FatFIRE retiree with income in the low six figures but already in the 22% federal bracket.
- You are in the top federal tax bracket of 37% and 20% for ordinary income and long-term gains, respectively. You also owe the 3.8% additional marginal tax for Obamacare.
- Let’s not forget about state taxes. The fourth regime has the highest federal bracket plus an additional 10% for state taxes.
To calculate the after-tax return of the box spread, I take the weighted tax rate (60% LT gains plus 40% ordinary income) and subtract that from the box spread yield. For comparison, I compute the “CD Equivalent,” i.e., the rate you’d need to fetch in a CD to match the box spread’s after-tax return. That’s easy to calculate; the box spread after-tax return is divided by one minus the ordinary income tax rate. For example, I’d need a 6.21% rate in a CD in the low-tax regime to match the 5.74% in the box spread. CD rates above 6% are not so easy to find right now!
The tax advantage of the Box Spread is a little smaller in the intermediate federal bracket. That’s because the S.1256 marginal tax rate is not too far below the ordinary tax rate (17.8% vs. 22%). However, with the higher tax brackets, the box spread becomes very attractive again relative to a CD. The ordinary income tax rate is 10.2 percentage points higher than the S.1256 contract marginal rate. Also, even when adding a state tax across the board and leaving the spread the same, the CD equivalent still becomes larger (dividing by one minus the ordinary marginal tax rate, we divide by a smaller number!). In the highest tax regime, you’d need to earn 6.93% in the CD to match the 5.74% in the Box trade. High earners in high-income-tax states will benefit most from the box trade!
How do I close the Box Spread?
There are multiple routes:
- Wait until the expiration, when all options expire, and you get your money back. There is no commission to pay.
- Close the box spread early by simply reversing the trades I explained above.
- What happens if your original box spread now has strikes far away from today’s index? Imagine you buy a 4000-5000 box spread, but subsequently, that spread now has wide bid-ask spreads. Can you sell a 5000-6000 box spread if its prices seem more attractive? Certainly. You will then hold multiple a collection of options at three different strikes, 4000, 5000, and 6000, that precisely offset each other and will expire with a $0 payoff at the expiration; see the table below:
And finally, you could also partially undo the $100k notional box spread. For example, if you have a long $100k notional box spread and need “only” $50k, you could borrow through a 4500-5000 box spread (or a 5000-5500 spread, or 5500-6000, whatever offers you the best execution). This move will partially liquidate the existing spread. You’re really only limited by transaction costs and B/A spreads. To save money, of course, it’s always best to hold the box spreads to maturity, which is what I’ve been doing so far.
Too lazy to trade the spread yourself? Try a Box Spread ETF!
If you’re overwhelmed with trading this yourself, do not despair. There’s an ETF for that. The Alpha Architect 1-3 Month Box ETF (BOXX) has been trading since late 2022. The advantage is that you can trade this in small lots and commission-free at Fidelity or most other retail brokerage firms, like Vanguard, Robin Hood, etc.
What kind of return can I expect from the BOXX ETF? It’s not so straightforward. The ETF does not pay out its box spread income but rather accumulates the gains. The advantage is that if you hold the ETF for more than a year, you can structure a CD-like return with the tax treatment of long-term gains. Sweet; that seems even better than building your own box spread, but you also pay the ETF expense ratio (0.19%). Also, the current BOXX yield seems a bit low. Since the ETF doesn’t pay any monthly dividends, we have to gauge the current yield from the price chart. That’s no easy task because the price chart for this ETF is quite bumpy; see the chart below (top panel). I tried two different routes to measure the yield:
- Calculate a 4-week moving average chart to smooth out some of the bumps. Then, take the 4-week return of that smoothed line and annualize it. That’s the blue line in the bottom chart. Currently, the annualized yield is about 5.12%.
- Calculate a Hodrick-Prescott Filter smoothed line (the red line in the top chart) and then calculate its 4-week return and annualize that, which I plotted in the green line in the bottom chart. The HP-filtered line is a bit better at eliminating the noise. The BOXX ETF price time series seems to have a slope consistent with a 5.20% annualized return.
Next, let’s perform the same calculations as before, i.e., calculate the BOXX ETF after-tax returns, assuming you can hold this fund for more than a year to structure your interest income as 100% long-term gains. To calculate the CD equivalent, we again divide the BOXX after-tax income by one minus the ordinary income tax rate; see the table below. If the BOXX yield is 5.20%, you’d still do better with the homemade Box Spread trade in the low and intermediate tax brackets. In contrast, the higher income tax brackets would benefit slightly from the BOXX ETF.
Some words of caution
Just for the record, there are some drawbacks of trading box spreads:
- More complexity: Sophisticated investors and financial advisers might benefit from this trade, but many ordinary investors are unwilling to trade options. I fully sympathize with that. If you invest a few thousand dollars, the tax advantage may not be worth the extra complexity. For larger amounts, though, six figures and up, you’re leaving a big chunk of money on the table by ignoring the box spread route.
- Credit risk: while your CD is insured through the FDIC up to $250k per bank, your box spread is only as credit-worthy as the options exchange. Even for very creditworthy players like the CBOE, you’d probably need to assume that about 0.3 percentage points of any excess yield might just be a credit spread, not free excess yield.
- Tax uncertainty: While the self-made box spread will likely always enjoy the 60/40 long-term/short-term tax treatment, some folks are concerned that the IRS may eventually crack down on the BOXX ETF, flaunting the ETF retained gains tax loophole. Before too long, the IRS may force the ETF provider to distribute the S.1256 gains regularly, i.e., monthly, like most other short-term fixed-income ETFs (e.g., SHV). Paying S.1256 on 5.2% income is still better than paying ordinary income tax on 5.2%, so BOXX would still have a tax advantage, albeit a smaller one. In that case, BOXX would fall behind the homemade box spread even for the high marginal tax households.
- Longer Horizon: To utilize the BOXX ETF tax advantage, you’d need to hold it for one year plus one day. Ideally, one would create a ladder of BOXX ETF tax lots so that we can always liquidate the shares that already qualify for long-term gains. If you have a specific cash flow need within one year, you’re better off using the homemade box spread.
- Illiquidity: Both box spread routes have some liquidity risk. The BOXX ETF has some volatility, and if you need your money back on a specific day, you may get a price a few cents below the trend line. Likewise, you may be unable to unwind the box spread quickly due to a potentially large bid-ask spread and nobody biting on your limit order. Your limit order might sit there for a few days until it goes through. Then again, some CDs also have the same problem (and potentially worse!) in the form of early redemption penalties.
Which Box trade is for you?
Using a side-by-side comparison, implementing the box trade yourself will likely beat the BOXX ETF. However, the BOXX ETF may work for smaller investors who like to dip their toes and make smaller investments and withdrawals. I trade both: 1) the homemade box trade at Interactive Brokers, where I trade all my other options. And 2) the BOXX ETF in our Fidelity brokerage account, which we use for cash management, i.e., where we have a few months’ worth of cash to pay our bills.
Conclusions
With the equity market sputtering a bit, uncertainty about inflation, interest rates, and the November election, some folks wonder if it’s wise to park some money in a safe asset for a while. With 5+% interest rates, that makes more sense than only a few years ago when interest rates were at rock bottom. I showed a few options with better yields than your average CD or money market fund, especially when you’re concerned about the after-tax yield, not just the headline number, where you run the risk of comparing apples and oranges, i.e., tax-advantaged box trades vs. low tax efficiency CDs and money market interest income. It’s not for everyone, but I’m just here to offer options, pun intended.