Guest Author: Dr. Wesley Gray, Executive Managing Member, Alpha Architect

Summary of Box Spreads: Borrowing and Lending via the Options Market

Box spreads represent an overlooked yet powerful tool in the options market, providing investors with opportunities to borrow and lend at interest rates comparable to, and sometimes better than, the rates offered in the treasury bill market. Traditionally, these spreads have been the domain of hedge funds, market makers, and proprietary trading firms, but retail investors can also benefit once they understand the mechanics.

Why Treasury Bills Aren’t Your Only Option

For retail investors, it’s common to park short-term cash reserves in a checking or brokerage account or invest in Treasury bills (T-bills) and money market funds. However, box spreads could offer an even better alternative from a risk-return perspective.

Treasury bills operate as zero-coupon bonds, where investors purchase the bond at a discount to its face value and receive the full value at maturity. For example, if you purchase a T-bill at $95, you would receive $100 at maturity, generating a return of about 5.26%. T-bills carry minimal credit risk and are exempt from state taxes, although most gains are taxed as income. This makes them a popular place to park excess cash. But box spreads offer an attractive, often higher-return alternative for savvy investors.

How Do Box Spreads Work?

Box spreads aren’t well known, even among many financial professionals. However, their mechanics have been studied by academics for decades. Box spreads essentially offer a “risk-free rate” similar to that of Treasury bills by utilizing the principle of put-call parity.

In a simplified explanation, put-call parity creates an arbitrage relationship between different options and their underlying assets. A box spread is constructed by executing four options:

• Long a call
• Short a call
• Long a put
• Short a put

A hypothetical example is the easiest way to understand why a box spread eliminates market risk.

Consider the following option position:

• Long a call and short a put
• The strike price of $4,000 on both options
• 1-year expiration on both options

The payoff profile of this position is outlined below in blue:

^{The examples presented above are for illustrative purposes only and not the return of any actual investment.}

The payoff profile resembles the exact profile of a long stock position delivered one year from now — if the price goes above $4,000, you make money, and if the stock price goes below $4,000, you lose money.

Let’s consider another option position: Long a put and short a call with a strike price of $5,000 and an expiration one year from now.

The payoff profile of this position is outlined below in blue:

^{The examples presented above are for illustrative purposes only and not the return of any actual investment.}

This chart looks a lot like a short position in the stock: You will lose money for every tick above $5,000 a year from now, and for every tick below $5,000 a year from now, you will make money.

Where does the box spread come in?

Simple: we execute on the two option packages above.

• Synthetic long: we go long the call and short the put at $4,000.
• Synthetic short: we go long the put and short the call at $5,000.

What happens when you combine a long and short position on the same asset?

You eliminate all market risks.

In the case of box spreads, you are left with a guaranteed payoff of the spread in strikes between the synthetic long position and the synthetic short position, which is $1,000 in this example (i.e., $5,000 – $4,000).

^{The examples presented above are for illustrative purposes only and not the return of any actual investment.}

We buy/sell this 4-option package, which will deliver us $1,000, no matter the stock price, one year from now.

If there is an opportunity to make $1,000, guaranteed, you aren’t going to pay $0 for that opportunity. What do you pay? $100? $500? You’ll probably pay a price that locks in a return similar to 1-year treasury bills. For example, let’s say the treasury bill rate is 5.26%. Maybe the box spread cash flow setup looks as follows:

^{The examples presented above are for illustrative purposes only and not the return of any actual investment.}

The synthetic long position costs you $2,950, and the synthetic short position gives you $2,000 for a net cash outflow of $950. But the box spread trade will deliver $1,000 a year from now. This implies that the return on this box spread is 5.26% ($50/$950), similar to the treasury bill rate.

Bottom line? When properly structured, a box spread eliminates all market risk, leaving a guaranteed payoff at the expiration of the options. This payoff closely mirrors the spread between the strike prices of the synthetic long and short positions created by the option contracts. In the example given in the text, if the spread between the long and short positions is $1,000, the investor is guaranteed to receive this amount regardless of the price movement of the underlying asset.

Box Spreads as Treasury Bill Substitutes

While you won’t necessarily become a billionaire using box spreads, they do allow for returns comparable to T-bills. For instance, in the example above, if the treasury rate is 5.26%, a box spread might deliver the same return, ensuring a $1,000 payoff at a cost that provides a similar yield to the treasury rate.

Historically, box spreads have delivered even higher returns than T-bills. Despite this, they are often overlooked by investors, partly because they are more complex than simply buying T-bills.

Risk: Counterparty Considerations

One of the most significant risks with box spreads is counterparty risk. While T-bills are backed by the U.S. government, box spreads rely on the Options Clearing Corporation (OCC) to guarantee transactions. However, the OCC has a strong track record, including clearing during the 1987 crash and the 2008 financial crisis, without any failures. The OCC’s credit rating is only slightly lower than that of U.S. government debt (AA compared to AA+), and as a “Systemically Important Financial Market Utility” (SIFMU), it has access to emergency liquidity from the Federal Reserve in case of extreme scenarios.

Practical Applications for Box Spreads

Retail investors and financial advisors can use box spreads as an alternative to letting cash sit idle in brokerage accounts or as a substitute for T-bills and money market funds. For example, instead of keeping excess funds in a low-interest checking account, investors could buy a box spread to generate a risk-free return comparable to or better than T-bills.

Box spreads also present an opportunity for sophisticated investors who utilize leverage in their investment strategies. Rather than borrowing from a broker at potentially higher interest rates, an investor could “borrow” from the options market by selling a box spread, often securing cheaper leverage than is available through standard margin loans.

Conclusion: Box Spreads may be an Alternative to Treasury Bills

Box spreads provide a unique way to lend and borrow in the options market with minimal risk and comparable returns to Treasury bills. Although still relatively unknown, their potential makes them an attractive tool for investors seeking a risk-free-like return on their cash reserves or leverage financing at better rates. With education and awareness, box spreads could become an essential part of retail investors' portfolios, offering an efficient, sophisticated way to manage short-term capital.

Investors interested in box spreads should familiarize themselves with the options market and consider working with financial professionals or tax advisors to optimize their use in practice.

About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children.

Note that this is a summary of a more detailed post on the topic of box spreads at Alpha Architect

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