Using Box Spreads To Get Cheap Leverage
(While not blowing up our account)
In The Last Few Years We’ve Seen All Time Low Interest Rates…
And with the Fed raising interest rates we may see the supply of cheap money get cut off for retail investors like us. But, there is a solution. Not only can we get cheap leverage, but we can get cheap leverage at institutional rates!
How can we do this? Simple, we use the market to lend us the money using options.
You may have heard of different multi-leg option combos before like iron condors, spreads, collars, straddles, butterflies, etc. However, there is one that you probably never heard of because it always loses money no matter what. But that’s a good thing because it allows us to do something that we can’t do otherwise. It allows us to borrow money at incredibly cheap rates and pay it back 1-3 years later. (Technically it works more like a line of credit because you don’t need to use the borrowed money and there is no principle payments, it just needs to be paid in full by the end of the term) This strategy is called a short box spread.
A short box spread involves opening both a bear put spread and a bull call spread. When all four options are combined they neutralize any gains or losses minus the cost of the options themselves.
Let’s Walk Through a Bear Put Spread and Bull Call Spread Quickly:
A bear put spread involves buying a higher strike price put and selling a lower strike price put. This effectively is the same as buying a put directly, except it puts a cap on possible gains (due to the short put) and reduces the possible loss because of the credit from the short put.
The payoff diagram looks like this with P/L on the Y axis and price on the X axis.
Alternatively, a bull call spread involves buying a lower strike call and selling a higher strike call. This also has the effect as acting as a long call except the gains are capped (again, from the short call) but losses minimized from the credit created by the short call.
The payoff diagram for the bull call spread, looks like this with the X and Y being the same as the last diagram.
You Might See Where This Is Going:
If we combine both of these strategies we get a payoff diagram that looks like this.
As you can see, regardless of whether the stock price goes up or down all gains or losses are hedged by the opposite spread. And because all gains or losses are hedged, than the only real loss comes from the cost of the options themselves.
Okay, I See Funny Lines Show That It Hedges All Risk, But How Does It Work In Practice?
Now we’ll walk through how the process of opening a box spread actually works, and we’ll show how assignment works when your box spread eventually expires.
However, we do need to preface this with an important point. Any box spreads that you open should only be done on ticker SPX. SPX is an S&P 500 index that uses European style options. This means that options can only be exercised on the day that they expire, not before. If you open a box spread on a stock using American style options, one leg of your trade can be exercised before the others UNHEDGING your box spread. YOU WILL NO LONGER BE PROTECTED FROM RISK IF THIS HAPPENS AND A MARGIN CALL IS LIKELY.
We like to start by going to boxtrades.com because it scrapes options data and calculates the best rates on box spreads without having to search the entire option chain and do it manually. Here we can pick what time frame we want the box spread for and how wide the spread is. The spread is the difference between the lower strike set of options and the higher strike set of options and it determines how much leverage can be achieved.
(For a good rule of thumb, on SPX box spreads every 1000 points is equivalent to $100k of leverage. 1000 points*100 shares).
According to the chart, there is a good box spread that can be opened for the 15 Dec 2023 expiry between 3000 and 4000 points with a 2.75% interest rate. So let’s take a look at yahoo finance options chain to find it.
In order to open the trade we need to sell a lower strike call and buy a lower strike put. Then we need to sell a higher strike put and buy a higher strike call.
In that case it breaks down to this:
Sell SPX 3000C 12/15/2023 for $1584.25
Sell SPX 4000P 12/15/2023 for $308.24
Buy SPX 3000P 12/15/2023 for $119
Buy SPX 4000C 12/15/2023 for $794
The credit comes out to be $1584.25 + $308.24 - $119 - $794 = $979.49. And remember, this is on a per share basis, so multiply that number by 100 and the actual credit is $97,949.
You might be thinking, the box is one-thousand wide though? Why are we not getting that full amount?
The answer lies in how the interest is paid. A box spread acts as a zero coupon bond, or essentially, the interest is paid through the discounted amount off of the face value. You only receive $97,949 because the remaining $2051 goes to the other side of the box trade to pay them for their trouble. You don’t technically need to pay this interest until the expiration of the box where you return the full $100,000.
Now given this discounted amount we can actually figure the APR of the box. Simply take the $2051 and divide it by the days until expiration (610 days at the time of this writing) and then multiply it by 365, then finally divide it by the amount that needs to be paid back (which gives us a 1.2% APR).
One thing to note, this APR can change depending on when you open the box. It usually is fairly close to the risk free rate (usually the ten year treasury yield is used for this). If your number is far above this you should not open the box due to a bad rate, and if the number is far lower you should be skeptical of whether you can actually get a fill at those prices (although it couldn’t hurt to try).
Expiration Of A Box Spread:
Although you might not want to let a box spread expire, and simply just close it before term, it’s a good idea to understand how assignment works on a box (which can further help you understand how it hedges you against all risk in a European style).
We’ll cover three situations, when SPX is below the range of your box, when SPX is inside the range the box, and when SPX is above the range of the box.
Below the Range
In the case of our 3000-4000 box spread let’s say that SPX is trading at 2000 at expiry. What happens? Well, our short 3000C expires worthless, because who would want to buy SPX at above market value which means we keep the $1584.25 premium.
However, our short 4000P expires in the money meaning that we need to “purchase” 100 shares at $4000 a piece although we get a $308.24 credit putting us at a net $1892.49.
But, remember, because we purchased a 3000P (which cost us $119) we can sell these shares from the short 4000P back at $3000 for a $1000 loss per share.
This puts us at a net premium of $773.49 ($1892.49 - $1000 - $119 = $773.49).
Now finally we have the 4000C that we purchased which will expire worthless (who wants to exercise an OTM call?) which cost us $794. This leaves us with a net -$20.51. This $20.51 is what we owe in “interest” on our box spread.
Inside the Range
What happens when SPX is inside the range of our box at expiry? Say 3500 points? Let’s walk through it. Firstly our short 3000 call gets exercised because it is in the money. We still keep the premium of $1584.25 but now we need to purchase shares at 3500 to sell for our call obligation. We take a $500 loss on those shares bringing us down to net $1084.25.
Next, our short 4000 put gets exercised as it is also in the money. We get credited $308.24 for this but need to purchase the shares at 4000 to sell at 3500 giving us a $500 loss. This brings our net to $892.49.
Lastly, both our long call and long put don’t get exercised as neither of them are in the money. Together they cost us $913 bring our net down to -$20.51.
Above the Range
Let’s now say SPX is trading at 4000 upon expiry. The first thing that happens is that our short 3000 call gets exercised because it is in the money. We get credited $1584.25 for this but we’ll need to exercise our long 4000 call to purchase the shares to sell them at a $1000 loss. This call cost us $794 bringing us to a net -$209.75 ($1584.25 - $1000 - $794).
Next, regardless of whether our short 4000 put gets exercised we get a credit of $308.24. We can then immediately turn around and sell these shares for what we purchased them for bringing us to a net $98.49.
Lastly, our long 3000 put doesn’t get exercised and it cost us $119. This brings our net to -$20.51.
As You Can See…
regardless of what the price of SPX is upon expiry of the box, we are completely hedged on all sides from any market risk, and we need to pay back the credited amount in full. Most likely you will want to simply close the box instead of going through assignment, but we thought it would be helpful to run through this first. Understanding box spread assignment is a bit confusing at first, so definitely read through it a couple times to make sure you understand fully, we know we had to.
How Does This Affect My Margin Requirement?
We want to stress something important here. Box spreads are only an alternative to brokerage financing. This does not get you out of meeting your margin requirements. If your account balance drops too low when you do this you will get margin called just as if you were borrowing from the broker themselves.
What your margin requirement is is beyond the scope of this article. But to break it down simply. You either have Reg T margin (which requires at least 25% maintenance) and Portfolio margin, which is calculated on the fly based on the risk of your holdings.
If you want to read more about Reg T margin look here. If you’re curious about Portfolio Margin you can take a look at TD Ameritrade’s structure.
Before going straight to using Box spreads for financing we recommend you look at the margin rates for the brokerage you use. Chances are if you use a brokerage like TD Ameritrade you’ll be better off using box spreads. However, with a brokerage like Interactive Brokers, you might get a better rate by financing with them. It can’t hurt to look around first.
Furthermore, we recommend that you do some additional reading on box spreads before attempting to carry one out. This reddit post is a great starting point, but there is plenty of other resources if you google “box spread financing.”
Anyway, That’s the Basics of Using Box Spread Financing.
We hope this article was helpful and insightful. If you liked it, please take a moment to share it with one of your friends! We’re sure it could help them too!
With that said…
Until Next Time!
Disclaimer:
All content is for discussion, entertainment, and illustrative purposes only and should not be construed as professional financial advice, solicitation, or recommendation to buy or sell any securities, notwithstanding anything stated.
There are risks associated with investing in securities. Loss of principal is possible. Some high-risk investments may use leverage, which could accentuate losses. Foreign investing involves special risks, including a greater volatility and political, economic and currency risks and differences in accounting methods. Past performance is not a predictor of future investment performance.
Should you need such advice, consult a licensed financial advisor, legal advisor, or tax advisor.
All views expressed are personal opinion and are subject to change without responsibility to update views. No guarantee is given regarding the accuracy of information on this post