Transcription
What if you could borrow at rates close to what the US Treasury pays and use the money for anything you wanted? And what if you got a tax deduction for doing so? This isn't a loophole. It's not something sketchy. It's a strategy that institutions and sophisticated investors have been using for decades. It's called a box spread loan, and in today's video, I'm going to walk you through exactly what it is, how it works, who it makes sense for, and what you need to know before even considering it.
This video is part one of a three-part series on box spread loans, and today we are keeping it high-level and practical, but parts two and three will go much deeper into the mechanics and the theory behind why this strategy works the way it does. If you're new here, welcome. My name is Eric Gouge. I'm a chartered financial analyst and a certified financial planner. I use this YouTube channel to share with you the things that I've learned and continue to learn as a financial planner working with high net worth, near retirees, and business owners. If you appreciate this content, it would genuinely mean a lot to me if you gave me a like and a subscribe. Let's get into it.
Let's start with the problem that a lot of investors with significant portfolios face: portfolios with large embedded gains. Life happens. Maybe you want to buy a second property, or an investment opportunity comes up, or maybe you just want access to liquidity without disrupting your investments. So, what are your options in these cases? Well, you could sell some of your portfolio, but of course, selling means triggering capital gains taxes, especially if those positions have grown significantly over the years. You're looking at a 15% to 23.8% tax rate there. You could take out a margin loan or a securities-backed loan from your brokerage account, but these can be convenient, but they have 7% to 10% interest rates, depending on your broker and your balance and so forth. You could take out a personal loan or a HELOC. These, of course, come with their own costs and conditions and credit requirements and timelines. And again, you're looking at a roughly 7% to 10% interest rate.
Here's the frustrating part. All of these options are fundamentally retail products. They are priced for you, the individual borrower, and because of that, there is a spread built in for the lender. But what if you could access something closer to the wholesale cost of borrowing? That is exactly what box spread loans offer.
So, what is a box spread loan? A box spread loan is an option strategy that has been used in markets for a very long time. It's not new, it's not novel, it's not risky. The way it functions as a borrowing tool is pretty straightforward once you see the basic idea. And here's the simplest way to think about it: You're going to be selling two options contracts, and you're going to be buying two options contracts. And the options contracts you're selling are worth more than the options contracts you're buying. So, you're getting money up front today, and you're owing a larger sum in the future. The four options contracts cancel each other out completely risk-wise. The options contracts are on the same underlying index, and this is typically the S&P 500 index, also known as the SPX. When structured correctly, these four contracts lock in a completely fixed payment at expiration, no matter what the stock market does between now and then. The market risk cancels out completely. Because the outcome is fixed and known in advance, the only thing being priced is time value, which is your interest rate. Now, the market prices these contracts to reflect implied interest rates that track very closely to what the US Treasury rates look like. To borrow money, an investor is going to sell a box spread, which is called a short box spread. They are essentially borrowing money from the options market at institutional rates. They receive cash upfront today, and they are agreeing to pay back a fixed larger amount at expiration. The difference between what they received today and what they pay back in the future is the interest cost.
So, let's take a simple, take a look at a simple hypothetical example to make this a little bit more concrete. And this is just for illustration purposes only, but imagine someone sells a box spread on SPX options with a 100-point strike width. You don't have to remember that it's 100 points or any of these numbers specifically. This is just for illustration purposes. But let's imagine they sell a box spread with a 100-point strike width, and this is called a 100-point box. They might receive $96.25 per unit today, hypothetically, and agree to pay back $100 per unit at expiration. And that is a $3.75 difference. That difference is their interest cost, which works out to roughly 3.9% annualized. Scale that up to a $500,000 position, and you're borrowing half a million dollars at roughly the same rate as a major financial institution. So, compare that to a margin loan at 7% or 8%. On $500,000, that's the difference between paying about $19,500, just under $20,000 in interest per year, versus $35,000 to $40,000 in interest per year. You're saving, what is that? $16,000 to a little over $20,000 a year in interest every single year. That adds up pretty fast.
So, why are the interest rates on box spread loans so low? The rates are not low because someone is doing you any favors. They are low because of how markets work. SPX options are among the most actively traded instruments in the world. There are thousands of institutional participants, market makers, hedge funds, and so on, constantly competing to buy and sell these contracts. That competition drives pricing to be extremely efficient. And options are priced by an arbitrage relationship that's called put-call parity. And I'll go into more detail on what put-call parity is in part two in the next video. But because a properly constructed box spread has no directional risk, the payoff is the same whether the market goes up or down or sideways, what you are left with is essentially a fixed-rate loan. And in a market with deep liquidity and intense competition, that loan gets priced to reflect wholesale borrowing rates, not retail rates. In practical terms, box spread rates tend to track very closely with Treasury rates plus a small spread, sometimes just 30 to 50 basis points or so. Currently, effective box spread rates are roughly 4%, depending on the duration you choose. And importantly, you can lock in these rates for a defined period. You can lock them in from a few months all the way out to 5 years. And that's a meaningful advantage over variable-rate margin loans, which can spike when interest rates rise. A HELOC or SP lock, for example, will not be able to lock in a rate for you. These are typically floating-rate loans, which exposes you to more risk than you otherwise need to be taking.
But one of the more compelling aspects of box spread loans, especially for high-net-worth investors, is the tax treatment. And this is where it gets pretty interesting. SPX options are classified as Section 1256 contracts under the Internal Revenue Code. That classification carries specific tax treatment. One consequence is that the interest cost embedded in a short box spread, the difference between what you receive and what you pay back, is treated as a capital loss, not as an ordinary interest expense. Why does that matter? Well, because capital losses are flexible. They can offset capital gains anywhere in your portfolio up with no cap, so dollar-for-dollar with no maximum amount, or they can offset ordinary income up to $3,000 per year and be carried forward indefinitely. Investment interest expense, by contrast, requires itemizing, among other things, but also comes with its own set of requirements that make it much less flexible. This creates a situation where not only are you borrowing at a lower rate than the alternatives, but the cost of that borrowing is also much more tax-efficient. For investors who are managing significant capital gains in their portfolios, that combination can be meaningful. In fact, it may offer you the opportunity to diversify some of those embedded gains in your taxable brokerage account because you're going to be getting a capital loss on the interest you pay from your box spread loan. Now, tax treatment is a nuanced subject, and all this depends very much on your specific situation. Always work with a qualified tax advisor before making any decisions based on any tax strategies, but the point is that on the tax dimension, a box spread loan has a real advantage that most traditional borrowing methods simply do not offer.
So, who are box spread loans for? Or more appropriately, who can take advantage of box spread loans? Well, they are not for everyone. This strategy is one that sits firmly in what I might call the advanced category, and it's important to be honest about who can genuinely take advantage of these. Now, I strongly advise against attempting to create a box spread trade on your own. You can do that, but I strongly advise against that. My firm, Uvest Advisory, is able to facilitate these transactions with partner firms who are specialized in managing these transactions. But there's a few things you need to know before you pursue this strategy if you think it might be a good fit for you.
First and foremost, this strategy requires a meaningful taxable brokerage account. The practical loan minimum to make transaction costs and the operational complexity worthwhile is generally considered to be somewhere around $50,000. Second, it generally requires options level two or three trading approval and margin access from your broker. Whether it's two or three depends on the broker that you are at, but in any case, you will need margin access from your broker. You cannot use IRAs or Roth accounts to back these loans, and these loans do have to be backed by a brokerage account. You have to use standard taxable brokerage accounts, so you will require margin access. You can typically borrow up to 50% of your taxable brokerage account balance. Third, you're going to need to be comfortable with the underlying concept of borrowing against your investment portfolio. I think this goes without saying, but if your portfolio, which is acting as collateral for this loan, declines in value, you could face what's called a margin call. Now, if you size the loan appropriately, the risk of a margin call can be significantly reduced. If you are borrowing the maximum amount, for example, if you're borrowing 50% of your portfolio, you will face a margin call if your collateral portfolio, the portfolio that's backing up your box spread loan, falls by 33% or more. The less you borrow as a percentage of your portfolio, the more of a drawdown you can sustain before facing a margin call. For example, borrowing 25% insulates you from a margin call all the way up to a 67% drawdown.
So, those are three things you need to be aware of if you are interested in pursuing box spread loans. If you check those boxes, though – meaningful portfolio size, options and margin access, and a solid understanding of the margin risk – and assuming you actually need access to the cash, then box spread loans deserve serious consideration. For the right investor, the comparison of a box spread loan to the other borrowing options is not particularly close. The rate advantage alone can translate to tens of thousands of dollars, and the tax deduction just adds to that.
If the strategy is on your radar, here are some practical realities that you should be aware of before moving forward. First of all, these loans have balloon payments at expiration. They do not have periodic payments like traditional loans. Rolling the loan, therefore, requires planning ahead. When your box spread expires, if you don't pay it off, you need to roll it, which means opening a new box spread position to maintain your borrowing. This, of course, introduces the risk that interest rates have changed meaningfully since you originally borrowed the money. I typically advise laddering maturities, so you're going to be spacing out the expiration dates of the money that you're borrowing so that not all of your borrowing renews at the same time. For example, if you're borrowing $100,000 and you wanted to borrow that for the maximum amount of 5 years, you might instead, instead of borrowing $100,000 due in 5 years, you might instead borrow, uh, $20,000 due in year one, another $20,000 due in year two, another 20 in year three, and all the way up to, uh, $50,000. And of course, you need to adjust these numbers to, uh, get to whatever number you are trying to borrow and the point you are trying to borrow. The point is that if you ladder these loans, you're spreading your risk out across the entire timeline instead of concentrating it on one point 5 years into the future.
Second, these loans can only be executed via European-style options to reduce what's called early assignment risk. Now, you don't really need to know a whole lot about the difference between European options and American-style options, but what you should know is that with American-style options, your options can be exercised against you. You can exercise them, or they can be exercised against you at any point, uh, before maturity, while, uh, European-style options, which technically have nothing to do with the continent of Europe, can only be exercised at expiration. SPX options are European-style, meaning they can only be exercised ex- at expiration and not before. And this is important because early assignment on American-style options would definitely disrupt your box spread trade. It would open you up to a massive amount of risk, which is to say you can't construct box spread loans on just any underlying index. Using SPX options as the index rather than individual stocks or some other index completely eliminates this risk.
Third, you need the right brokerage setup. Not all brokers are going to handle box spread loans efficiently. You do not want to be in a situation where you, where you are manually constructing box spread loans. They can be manually constructed, but you are running a very high risk of getting poor, what's called, poor execution. And if you get really bad execution on a manually constructed box spread, for example, if you are not able to sell your options contracts for as much money as you otherwise could, and you're not able to buy the two option contracts that you need to buy as cheaply as you otherwise could, then you run the risk, even tiny differences, you run the risk of having a massively larger im- implied interest rate on your loan. So, do not try to do that manually. Whether you can do it at your broker depends on whether your broker is set up to handle them. I know that most of the large, uh, brokers handle them pretty well, Fidelity, Schwab, and so forth. Some of these smaller, more retail-oriented brokers, I can't vouch for, but that is something to be aware of.
And finally, everything I've said up to this point supports this final recommendation, and that is to work with a professional who understands this strategy. The combination of options mechanics, margin requirements, and tax treatment makes this strategy one where good guidance is genuinely valuable. Getting any one of these pieces wrong can turn what you think is a smart borrowing strategy into a very expensive mistake. So, work with somebody who understands what a box spread loan is and how to set them up appropriately, and just as importantly, how to manage them.
Okay, I want to leave you with a clear sense of where this series is going because today we covered the big picture. In part two, we are going to go much deeper into the actual mechanics of how a box spread is constructed. Specifically, I'm going to show you why a box spread has a fixed rate, why the loan in a box spread is is fixed, why it doesn't matter what the market does, and and prove to you that it doesn't matter what the market does. I'm also going to show you why the interest rates are so low. No matter what happens, the market is not going to produce interest rates that are higher than a few basis points above the risk-free rate of interest. And in part three, we're going to look at margin and structuring these loans and the investment implications of trading with margins. We might also take a look at any tax advantages and anything I can think of between now and the time I actually shoot the third part. So, if you have any recommendations, I would love to hear from you on that. If you want to make sure you catch both of those further videos, please hit subscribe and turn on your notifications so you do not miss them. And if something in today's video raised a question specific to your own situation, whether this kind of borrowing makes sense for your situation or your portfolio, your goals, your taxes, etc., that's exactly the kind of conversations I have all the time here at Uvest Advisory. Feel free to click on the link in the description and reach out to us. All right, that was part one. Thanks for watching, and I'll see you in part two.