Legging When Trading Options
Legging is a technique that most options traders will probably want to use at some point. In fact, traders that are using some of the more complicated strategies that can involve multiple transactions will almost certainly have to use it on occasion. Its use can sometimes be quite complex, but the basic concept is actually relatively simple.
When you use an options trading strategy that does involve multiple transactions, you are essentially entering several individual positions that are then effectively combined in one overall position, and each of those individual positions is known as a leg. You may choose to make all of those transactions at the same time, but sometimes there may be reasons why you choose to, or have to, make those transactions separately.
In very simple terms, legging describes the process of making each of those transactions separately. Traders generally use this technique either when they are unable to make all the required transactions simultaneously or when it's potentially more profitable to make them individually.
It can also be used to change the dynamics of an existing position if there is a good reason to do so. For example, if there's change in the way the market is moving, you will want to change the dynamics accordingly. On this page we explain legging and its purpose for options trading in more detail, covering the following:
- Legs and Legging Explained
- Reasons for Using Legging
- Ordering Legs Correctly
- More on Putting Legging to Use
- Risks of Using Legging
Legs and Legging Explained
As explained above, the basic definition of a leg is that it's one component of any options trading strategy that requires making more than one transaction. Most strategies involve creating spreads, where you effectively create a single position by entering two or more positions on options based on the same underlying security. These spreads are used for a variety of reasons, but they are generally used to either reduce the initial outlay of taking a particular options position or to reduce the risk of holding that position.
For example, one of the more straightforward strategies is the bull call spread, which involves the purchase of in the money or at the money calls on a specific underlying security and then the writing of out of the money calls based on the same underlying security. This strategy involves two legs; the buying of the calls is one and the writing of the calls is the other. Typically you would transact both of these simultaneously when putting on a bull call spread, but there may be occasions when you transact them separately and this is the process known as legging.
If you bought the calls on one day, and then wrote the calls the following day you would have just used the legging technique. Specifically, this is legging into a position, because you have created the spread by making separate transaction. It's also possible to leg out of a position too. If you had created a bull call spread and then decided you wanted to buy back the calls you had written, this is known as legging out of a position. We discuss the reasons why traders use these techniques below.
Reasons for Using Legging
Legging is a very widely used technique in options trading, particularly by experienced investors and traders. There are a number of reasons why options traders may choose to leg into and out of positions, the following reasons are most common:
- A broker may not be able to carry out each transaction simultaneously
- It may not be profitable to carry out each transaction simultaneously
- It may be possible to make additional profits by legging into, or out of, a position
- Circumstances could change, and it may be necessary to alter the dynamics of an existing position through legging
- It may be prudent to leg out of a position to lock in profits or cut losses
The advent of online brokers has greatly reduced the probability of the first reason being an issue. Back when you would need to use a telephone to contact your broker and place your orders, it may have been very difficult to get multiple orders all transacted at the same time. However, most modern online brokers allow you to make multiple transactions simultaneously and many have built in functionality specifically for this purpose. As such, legging tends to mostly be used to improve the profitability of combining multiple positions into one effective position.
One of the main drawbacks of using the strategies that require entering multiple positions is that a combination of the bid ask spread and the commissions charged by brokers can greatly reduce the potential profits you might make. In fact, there are times when those costs of trading can basically eliminate all the profits from an otherwise profitable trade. It may be necessary to make each of the transactions separately, and at the very best possible price, to give you the greatest chance of making a profit.
It's also worth noting that if you were trying to place all your orders at the same time, you would probably have to use market orders to ensure that all your orders were filled. Because market orders are filled at any price, and the market is constantly moving, there's no guarantee that you will get your orders filled at favorable prices.
By legging into each component of the overall position individually, you stand a much better chance of getting the prices you need. The same is true when exiting a position; you can potentially make greater returns by exiting each component one by one.
When the market is moving quickly in a particular direction, you can also increase your profits by using legging to fill each component of a position in the right order and at the best possible time. Arranging the order of your legging correctly is crucial, and can lead to much greater profits. It's also possible to make bigger profits or prevent losses by altering the dynamics of an existing position through legging: if the market starts moving in an unexpected direction for example.
Ordering Legs Correctly
If you are using legging specifically to try and increase profits by taking a particular position, then getting the order of the legs rights is absolutely vital. When done correctly, you can benefit greatly from the market movements, but getting it wrong can be very costly. The basic principle is to try and first transact the orders that will be hardest to fill based on the way the market is moving. As an example, let’s look at a bull call spread as we have referred to above.
If the market was relatively stagnant, then you would probably look to place the orders required for the bull call spread simultaneously. However, if the market was rising reasonably quickly, then you could use legging to increase potential profits. When the market is rising, then the price of calls is generally rising too. It's essentially harder to fill buy to open orders on calls at favorable prices, but easier to fill sell to open orders on calls.
You should look to complete the transaction that involves buying call options first. Once you have that order filled, you can then look to write calls on the same underlying security. If the price of that underlying security has gone up in that time, then you will get a more favorable price for selling your calls than you would have done if you had sold them. If you had made the orders the other way around, then you would have received less for writing the calls, and paid more for buying the calls.
To some extent this is common sense, but it should be stressed that you should always look at which way the market is moving and act appropriately to maximize potential profits. The ordering of your transactions depends on what trades you are making and which way the market is moving. The basic principles are as follows:
- In a rising market, buying calls and writing puts is generally harder to do at a favorable price than writing calls and buying puts. As such, if your strategy involves buying calls and/or writing puts you should make those transactions first. If it also involves writing calls and/or buying puts then those transactions should be carried out later.
- In a falling market, buying puts and writing calls is usually more difficult to do at an advantageous price than writing puts and buying calls. Where your strategy involves buying puts and/or writing calls, those are the transactions that should be carried out first. Any required orders for writing puts and/or buying calls should be made subsequently.
More on Putting Legging to Use
Another way to use legging is when the market changes direction or there are other unexpected circumstances which could affect the profitability of an existing position. It may be possible to exit one specific position, or enter into another, that changes your overall position and either increases your profits or reduces your losses.
Let’s again use the example of using a bull call spread. In this example, you have taken a long position by buying calls on a specific underlying security and combined that with a short position by selling cheaper out of the money calls on the same underlying security, with the expectation that the price of the underlying security will go up by a moderate amount.
The best situation with a bull call spread is that the underlying security does go up in value by an amount large enough to return a profit on the calls you have bought, but by a small enough amount that the calls you have written don't get into the money: meaning you profit from both parts of the spread.
If the underlying security actually goes up significantly in value, you will still make a profit on the calls you bought, but some of those profits would be offset by losses on the calls you wrote. If you acted quickly enough once you realized the security was going up more than expected, you could exit your short position and buy back the calls you wrote at a small loss.
With the underlying security continuing to rise, you have made additional profits on the calls you bought, but you've only made a small loss on the short position so you increased your overall profitability.
Equally, you could use legging to cut your losses on a trade. Again using the above example, if the underlying security actually fell in value, then you would profit from your short position with the calls you sold, but you would lose more on the long position with the calls you bought. Had you seen this price fall coming, then you could have closed your long position and sold your calls at a loss before the price fell too much. This loss would then be covered either partially or wholly by the profit on the short position.
As you can see, legging is a technique that has a number of uses and for the active trader it can represent a great way to not only potentially increase profits but also get out of bad trades and to generally be a more efficient trader. However, it isn't without its risks and it's very important to be aware of the potential downsides.
Risks of Using Legging
The first thing that we should mention regarding legging is that it's really not a technique that is well suited for beginner options traders. Although the basic concept is pretty easy to understand, putting the technique to use is somewhat more complicated.
To successfully use it, you should be able to fully understand the implications of what you are doing, and also be able to recognize short term trends in the market. Ideally you should be able to make calculations and decisions quickly to determine exactly when the right time to leg into, or out of, any particular position is.
When used correctly, it can turn unprofitable situations into profitable situations or increase the maximum profits of a situation overall. The biggest risk, though, is that if you get it wrong you will either reduce the profits you might or even turn those profits into a loss.
If you mistime the completion of legs, or carry them out in the wrong order, you can end up in a position where you have absolutely no chance of making any money. Legging definitely has strong advantages, but you simply must be aware of the risks involved and be absolutely sure you know what you are doing before attempting to use this technique.