What Is a Leg?
A leg is one component of a derivatives trading strategy in which a trader combines multiple options contracts, futures contracts or – in rare cases – combinations of both to hedge a position, benefit from arbitrage or profit from a spread. Within these strategies, each derivative contract or position in the underlying security is called a leg. The cash flows exchanged in a swap are also referred to as legs.
The Basics of a Leg
A leg is one part or one side of a multistep trade. These kinds of trades are just like a race of a long journey – they have multiple parts or legs. They are used in place of individual trades, especially when the trades require more complex strategies. A leg can include the simultaneous purchase and sale of a security.
For legs to work, it's important to consider timing. The legs should be exercised at the same time in order to avoid any risks associated with fluctuations in the price of the related security. So a purchase and sale should be made around the same time to avoid any price risk.
There are multiple facets to legs, which are outlined below.
Options are derivative contracts that give traders the right, but not the obligation, to buy or sell the underlying security for an agreed-upon price – also known as the strike price – on or before a certain expiration date. When making a purchase, a trader initiates a call option. When he sells, it's a put option.
The simplest option strategies are single-legged and involve one contract. These come in four basic forms:
|Long call (buy a call option)||Short call (sell or "write" a call option)|
|Short put (sell or "write" a put option)||Long put (buy a put option)|
A fifth form – the cash-secured put – involves selling a put option and keeping the cash on hand to buy the underlying security if the option is exercised.
By combining these options with each other and/or with short or long positions in the underlying securities, traders can construct complex bets on future price movements, leverage their potential gains, limit their potential losses and even make free money through arbitrage – the practice of capitalizing on rare market inefficiencies.
Two-Leg Strategy: Long Straddle
The long straddle is an example of an options strategy composed of two legs, a long call and a long put. This strategy is good for traders who know a security's price will change but aren't confident of which way it will move. The investor breaks even if the price goes up by her net debit – the price she paid for the two contracts plus commission fees – or if it decreases by her net debit. She profits if it moves further in either direction, or else she loses money. Her loss, though, is limited to her net debit.
As the chart below shows, the combination of these two contracts yields a profit regardless of whether the underlying security's price rises or falls.
Three-Leg Strategy: Collar
The collar is a protective strategy used on a long stock position. It comprises three legs:
- a long position in the underlying security
- a long put
- a short call
This combination amounts to a bet that the underlying price will go up, but it's hedged by the long put, which limits the potential for loss. This combination alone is known as a protective put. By adding a short call, the investor has limited his potential profit. On the other hand, the money he receives from selling the call offsets the price of the put, and might even have exceeded it, therefore, lowering his net debit.
This strategy is usually used by traders who are slightly bullish and don't expect large increases in price.
Four-Leg Strategy: Iron Condor
The iron condor is a complex, limited risk strategy but its goal is simple: to make a bit of cash on a bet that the underlying price won't move very much. Ideally, the underlying price at expiration will be between the strike prices of the short put and the short call. Profits are capped at the net credit the investor receives after buying and selling the contracts, but the maximum loss is also limited.
Building this strategy requires four legs or steps. You buy a put, sell a put, buy a call and sell a call at the relative strike prices shown below. The expiration dates should be close to each other, if not identical, and the ideal scenario is that every contract will expire out of the money – that is, worthless.
Futures contracts can also be combined, with each contract constituting a leg of a larger strategy. These strategies include calendar spreads, where a trader sells a futures contract for with one delivery date and buys a contract for the same commodity with a different delivery date. Buying a contract that expires relatively soon and shorting a later (or "deferred") contract is bullish, and vice-versa.
Other strategies attempt to profit from the spread between different commodity prices such as the crack spread – the difference between oil and its byproducts – or the spark spread – the difference between the price of natural gas and electricity from gas-fired plants.
- A leg is one part of a multistep trade.
- A trader will implement legs in his or her strategy to hedge a position, benefit from arbitrage or profit from a spread.
- Legs can be part of various strategies including a long straddle, a collar and an iron condor.