This one of my favorite investment strategies. The box position was historically used to delay taxable events. I have discovered an alternate use for this position to realize huge gains if used in conjunction with trailing stops when a significant change in the stock price is expected (i.e. quatrerly earnings reports, result of a legal case). Before I get into my trading strategy lets take a closer look at the definition and prior use of this technique.

Definition

The act of short selling securities that you already own. This results in a neutral position where your gains in a stock are equal to the losses. For example, if you own 100 shares of ABC and you tell your broker to sell short 100 shares of ABC, you have shorted against the box. An alternative to short selling against the box is to buy a put on your stock. This may or may not be less expensive than doing the short sale.

Historical Reference and Explanation

Also known as "shorting against the box".
 
Investopedia Says...     Before 1997, the sole rationale for shorting against the box was to delay a taxable event. According to tax laws that preceded 1997, owning both long and short positions in a stock meant that any papers gains from the long position would be removed temporarily due to the offsetting short position. All in all, the net effect of both positions is zero, meaning that no taxes need to be paid.

Let's say that you have a big gain on some shares of ABC. You think that ABC has reached its peak and you want to sell. However, the tax on the capital gain may leave you under-withheld for the year and subject to penalties. Perhaps the next year you expect to make a lot less money, putting you in a lower bracket and causing you to want to take the gain at that time. However, the Taxpayer Relief Act of 1997 (TRA97) no longer allows short selling against the box as a valid tax deferral practice. Under TRA97, capital gains or losses incurred from short selling against the box are not deferred. The tax implication is that any related capital gains taxes will be owed in the current year.

Short Against the Box for a Profit

Here is an example of how I use this technique to realize gains surrounding a significant change in the price of a stock. A significant change in the price of the stock can occur in either direction as a result of a earnings report, a media event, or volatile market condition. In the case of the stock depicted below I established a short and long position of equal weight at $39.00 per share. A bad earnings report was released after hours followed by a dive in the stock price the following day. Trailing stops were placed at 5% on both the short and long position establishing a 10% no profit channel. The long position stops out at 5% loss and profit starts on the short position. Cover the short at anytime after the stop out to capture profit. See figure below for further details.


Note: Most brockerage firms will not allow a box position to be taken on a stock. You may need to setup two separate accounts to handle this type of transaction (i.e. long position with TDAmeritrade and short postion with Scottrade). Also beware of the risk if the trailing stop is to close to the short and long position price (i.e. 2% on both sides). This may result in the stock oscillates in both directions stopping you out of the long and short positions. There is also a risk that the stock price may gap the next day resulting in the trailing stop activating at a much higher percentage of loss than expected. For example the stock price could have gapped and opened at $31.50 resulting in a trigger of your trailing stop for the long position at 21% rather than 5%. This technique is best played when the change in stock price occurs during market hours.

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