What Does Legging in Mean?
Legging in refers to the act of entering multiple individual positions that combine to form an overall position and is often used in options trading.
- Legging in refers to the act of entering multiple individual positions that combine to form an overall position and is often used in options trading.
- Legging in to a complex strategy can be advantageous to a trader, if putting on the position one piece at a time will prove to be less expensive that establishing it all at once.
- There is risk associated with legging in, namely leg risk, which is the risk that the market price in one or more of the desired legs will become unfavorable during the time it takes to complete the various orders.
Understanding Legging In
Legging in can involve establishing a spread, combination, or any other multi-leg position in options one leg at a time, rather than all at once as a single package. Legging in to a complex strategy can be advantageous to a trader, if putting on the position one piece at a time will prove to be less expensive that establishing it all at once.
For certain complex positions, if a trader cannot find an eager counterparty who happens to have an axe to put on the exact opposite position, he or she may not find enough liquidity or a favorable price by quoting it as a spread. Instead, it may be better to leg into the spread one option at a time until finished. Upon taking off, or closing out, a complex position, a trader may similarly leg out of it.
Legging in may also refer to the setting up of an entry position of a complex financial investment separately from setting up the exit or unwinding of the position; or when a debtor or creditor enters into a hedging contract after the debt instrument has been issued or acquired in order to lower financial risk.
Legging in is a common practice used to lower the overall cost when buying and selling complex strategies involving options and futures contracts. Spreading strategies in the options market is popular, since it allows a trader or investor to customize a particular profit and loss structure when betting on a specific outcome or set of outcomes in the underlying security.
While there are several standard spreads and combinations, such as vertical call spreads, butterflies, or straddles, a trader can build whatever spread strategy they like. As a result, complex orders involving more than two options might not find a natural counterparty eager to take the other side of the trade, at least not for a favorable price level. Therefore, it is worthwhile to leg in to the spread piecemeal.
While a legging process may prove to be cheaper, it does come with some risk, known as leg risk. The risk is that the market price or liquidity in one or more of the desired legs will become unfavorable during the time it takes to complete the various orders. This can happen because the underlying security moves sufficiently in between legging, or because of other factors like a change in implied volatility. Additionally, while you are trading one leg, somebody else may effect a trade in another leg you are looking at purely incidentally.
Example of Legging In
For example, suppose a trader has a particular desire to enter into a complex multi-leg options strategy involving buying the 30 – 40 strike 1 x 2 put spread in XYZ options and at the same time buying a 50 – 60 strangle. The trader initially might quote the combined strategy as a package to see what people are willing to sell it at. If the offers in the market for the package are not to the traders liking, then the trader may try to leg into the strategy by quoting the two spreads separately. Perhaps he finds a good offer for the strangle, but is still unhappy with the 1 x 2 ratio put spread offer. He buys the strangle and then goes to the electronic market's screens to buy the 40 put by itself and then sells two times the 30 puts to a market maker on the floor. The trader has successfully legged into the full strategy.