If you’re thinking of legging in to options spread strategies, know the pros and cons before diving in.
If you’re thinking of participating in the world of “legging,” there are some things to consider. James Boyd, Education Coach at TD Ameritrade, explains the good and the bad.
When you trade a multi-leg options spread, do you need to enter and exit the legs in the same transaction, or can they be done separately?
That’s a great question. When you’re thinking of creating an options spread position, you don’t necessarily have to buy or sell the different legs simultaneously. For example, if you’re creating a put vertical spread, you could leg in to the trade—enter an order for the long put, wait till the order gets filled, then enter an order to sell the short put.
It’s the same with the exit. You could exit both in the same transaction, or leg out of each one in separate transactions. For example, if you set a predefined place to exit your trade—a support area or a price target—you could plan to exit one of the legs when it reaches your target. Say your order to sell the long put gets filled. The short put will still be remaining. And if that short put could benefit from time decay and volatility contraction, you might decide to stay in that short put a little longer. But, a short position can be assigned at any time regardless of in-the-money amount. Plus, you’re likely leaving the short put naked, which could result in a hit to your available capital because of the margin requirement on the naked option.
What are the pros and cons of legging into trades?
Getting a good fill is important for a trader. Stocks with higher volume are likely to have higher options volume. And higher volume could mean better fills. Of course, month and strike selection and other factors can affect volume as well.
The reason you might consider legging into a trade is to potentially get a better fill. But after that first leg is filled, you’re taking a chance with the price of the second leg. Things could go your way, and you may end up getting filled at a better price. But there’s also the likelihood things may not go your way. In that case, you may not be able to get in to the second leg at the price you want. That could even discourage you from getting in to the second leg, leaving you placing only one leg of the trade. That could mess up your original trading strategy.
Legging in and out of trades also requires discipline. Say you were selling a call vertical spread. You entered the short call first, and the price of the underlying shot up. You’d be losing on that short call option, and you’d have to try to buy the long call at a higher price. On top of that, you may have a margin call because the system won’t know you have plans to buy an option against that short call. It will look at that order as a naked one, which has unlimited risk.
So, legging in to trades can work if you get the timing right, but there’s a chance that things may not go your way. Before deciding whether or not to leg in, think hard about the reason you want to place the trade in the first place. If you do decide to leg in to the trade, always have a plan B.
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