Hey everyone.
This is Kirk, here again at optionalpha.com.
In this video tutorial, I want to talk about the concept of legging into or out of option
trades.
This concept is where you would basically enter one side or one part of a trade and
then later on add the other side or other part.
This really doesn’t apply to single leg option trades.
It’s really multi leg trades and these would be things like credit spreads, iron condors,
butterflies, strangles, straddles, whatever the case is.
Anytime that you’re trading multiple different sides of trades, you could argue that sometimes
you could leg into or out of trades.
For example: If you wanted to leg into an iron condor, you might add the put credit
spread side first and then later on add the other side of the trade which is the call
credit spread side and create that iron condor.
Again, this is different from just entering both sides at the same time and trying to
fill all of the same strikes at the same time.
You’ll be doing separate orders and trying to at some point maximize a gain in differential
between the two strikes.
We personally don't prefer to leg into or out of many of the trade because of the directional
risk of the market.
Unless you are incredibly fast and you might gain some edge in legging into a trade or
legging out of a trade, but it's really not typical.
For us, we just don’t want that risk that between the time we place one side of the
trade and the time we place the other side of the trade that the market might move against
us.
We don’t know.
The markets are moving incredibly fast these days, so we don't want that directional risk
and that’s basically what happens.
Now, the only good part about legging into a trade or legging out of a trade is that
it sometimes is easier to get a fill and that's because the market on the other side or the
other party in the transaction just has to fill two sides, two different options versus
four where they have to fill four versus eight.
That can be a little bit beneficial, but I’m definitely of the opinion and definitely a
little bit more conservative trader that I want to know exactly what I’m going to get
into or out of with a complete strategy at one single time.
Let’s actually go over an example of how you would do this.
Inside of our Thinkorswim platform here is a chart of TLT which is tracking bonds.
We think that bonds are relatively overbought right now and implied volatility in bonds
is very, very high, it's up in the 74th percentile.
If we wanted to do some sort of iron condor trade in bonds and we wanted to leg into it,
here’s how we might be able to do that.
Again, this is why I don't prefer it, but I’ll show you exactly how we would do that.
Let's say we wanted to first sell the put spread side at somewhere around 125/124.
We would place a separate order for the 125/124 put spread and take in $.17.
Whenever that order fills or if it doesn't fill, we would also at the same time place
an order above the market at say 140/141, so we would do the exact same thing on the
other side of the market.
You can see this is just a combination of two different strategies where we take in
a $.17 credit and a $.14 credit.
It basically gives us about a $31 credit on the overall trade if we filled at those exact
prices.
Again, we’re just doing two separate orders here, two separate verticals, legging into
the put side and then separately legging into the call side.
This is different than if we just decided to do this trade all at one time.
This is what that order would look like if you did the iron condor all at one time.
You see it goes through that same credit of $31, but now it becomes one order that gets
filled in the market with all of the same strikes that you're looking at, but now it's
one order in the market.
It might be a little bit harder to fill because you got to get all the pricing right for four
different strikes, but we prefer to do this because we don't want to see the market move
one way or another.
Often what a lot of guys will try to do out there (or girls, if you’re trading) is that
they’ll try to add the put side of the trade, so below the market and then hope that the
market rallies higher, so that they can add the call side later at a higher price.
At that point, you’re getting a little bit directional in your trading and that’s okay,
to be sometimes directional, but not when you're entering new strategies and new trades.
You need to realize that over time, the more of these decisions that you make where you
try to guess where the market may or may not be going in the future, the less likelihood
you’re going to be successful doing it, you’re going to end up being at about a
50/50 bet.
That's one way to leg into a trade and what we feel is just a really disadvantage to doing
that is just the directional risk.
Now, let’s say however that you want to get out of a trade and leg out of a trade.
Here is an IWM put spread that we have, the 108/106 put spread and it’s making a little
bit of money right now.
The key is that sometimes, people will try to leg out of these trades.
For example: This short put that we had sold for $131 is now worth $53.
We’ve made about $77 on this particular leg of the strategy.
Some guys would try to buy this back out and close out the trade, but at that point, we’re
now holding long a put option that’s worth $38.
They don’t realize that your risk is still to lose that $38.
This short put that we had sold that's still worth $53 is covering the risk of the long
option at this point.
Legging out of a trade as well when there's still some significant value left in these
options can be very, very detrimental to your portfolio because of this unseen risk that
you might have in losing money on that side of the trade.
With this particular example, the risk is that we get out of the 108 puts and the 106
puts expire worthless, we lose an additional $38 on the trade here and it really doesn't
make sense to be doing this side of the trade.
Hopefully this video has been really helpful just to go through the particulars of how
to leg into or out of trades and our opinion on whether or not you should do it with your
trading.
As always, if you have any comments or questions, please ask them right below in the video show
notes.
Until next time, happy trading!