How to unbox tax savings with a four-sided options strategy

An options strategy called a "box spread" is gaining steam by the billions as an alternative to Treasury bills and traditional loans.

The tactic gets its name from the four-sided structure of options trades that simultaneously bet on calls and puts at strike prices for securities at a reliable spread. Potential tax and lending advantages are driving the appeal of box spreads, according to Brent Sullivan, a consultant on product distribution to sub-advisory and ETF firms. He's the author of the Tax Alpha Insider blog, where Sullivan wrote in October that $1 trillion in box spread assets are "up for grabs." 

In an interview, Sullivan said he came to that conclusion by comparing the appeal of box spreads to T-bills, securities-backed lines of credit, margin loans and home equity lines of credit. For financial advisors with clients who may otherwise do basic tax-loss harvesting, the strategy provides "another way to generate losses that can offset gains in their portfolio" through ETF issuers who are "essentially selling a zero coupon bond," he said. The Alpha Architect 1-3 Month Box ETF (ticker: BOXX) has built more than $9.3 billion in client assets, and Sullivan is closely watching a half dozen other products that are already adding to the momentum.

"You don't have to sell anything, you don't have to pay any tax. You borrow against your assets and you pay your loan back," he said. "Thats why what we're seeing is a ton of vendors rushing into this space. …  I'm going to call this the first stages of a gold rush."

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How box spreads work

As in other areas of tax-focused investing such as long-short strategies and Section 351 conversions, the ETF structure is giving advisors and their clients more opportunities to use tactics that were once available only to ultrahigh net worth investors. While T-bill gains usually amount to federal income for tax purposes and are often exempt from state-level duties, box spreads' treatment differs a lot. If the options in the box spreads apply to indices, the gains will get short- and long-term capital gains rates, which are often lower than basic income. And the interest on the debt generates losses, according to a guide by SyntheticFi, which offers securities-backed loans tied to options on the S&P 500 Index.

"When clients use box spreads to borrow money, they will receive the principal when opening the trade, and pay the principal plus interest at settlement time," it said. "That means they will incur a loss equal to the interest expense. Such losses will be treated as capital losses (60% long-term and 40% short-term). Clients who want a fixed interest rate can enter into a box spread contract that lasts multiple years. In these cases, the interest is not paid until the options expiration date. These clients can claim a capital loss each year: for tax purposes, custodians will use the fair market value to calculate the losses on those contracts at the end of each year. The losses based on fair market value will be equal to the accrued interest for that year."

Risks include the possibility that lenders aren't able to pay the strike price, the cost of any transaction fees or commissions, interest rates and inflation, according to the Options Clearing Corporation, which has a guide to box spreads on its OptionsEducation.org website. Borrowers get "competitive interest rates while knowing the contracts are cleared, settled, and guaranteed by" the largest equity derivatives clearing organization, "thus eliminating counterparty risk," the guide said. Box spreads work the best for "institutional traders or experienced individuals who can better price the strategy and manage the position accordingly," it said.

"A box spread is a complex, four-sided options strategy that can be viewed as a synthetic long stock position (long call, short put) paired with a synthetic short stock position (long put, short call) at a different strike price with all four legs having the same expiration date," the guide explained. "From the buyer's perspective, the box spread would consist of a bull call spread and a bear put spread. The bull call spread involves buying a call option at one strike and selling another call at a higher strike. The bear put spread consists of purchasing a put option with the same strike as the short call and selling a put option with the same strike as the long call with all four legs having the same expiration date. Keep in mind, the buyer of a box spread is essentially loaning money to the seller for a fixed return on their investment."

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Good questions for advisors to ask

To Sullivan, the growth in box spreads represents another example of the "fiduciary-ization of brokerage products," he said.

"The advisor is required to act in your best interest, and that means that they cannot rip your face off on pricing and execution," he said. "All the partners in the stack are now focused on the same goal, which is getting the end investor the best deal."

With investors gravitating toward box spreads, the types of questions that advisors ask Sullivan more frequently revolve these days around distinguishing between the available choices, rather than simply trying to grasp the strategy. When speaking with one of the expanding ranks of providers, he suggested advisors should "validate how good of an executor they are," then proceed to weighing the term of the financing against the expenses.

"What advisors should be looking for there is just experience and depth," Sullivan said. "As they all sort of look the same, then price becomes one of the natural differentiators."