What's the Risk of Legging Into Spreads?

Key Concepts

• Vertical Spread: An options strategy involving buying and selling options of the same type (calls or puts) with different strike prices, but the same expiration date.
• Legging In: Executing a multi-leg strategy (like a vertical spread) one leg at a time, rather than as a single transaction.
• Execution Risk: The risk that a trade will not be filled at the desired price due to market movements or liquidity issues.
• Degrees of Freedom: In statistics, the number of independent pieces of information available to estimate a parameter. In this context, it refers to the number of choices a trader has when constructing a trade.
• Delta: A measure of an option's sensitivity to changes in the underlying asset's price. A spread has a combined delta, which is generally more stable than the deltas of the individual legs.
• Limit Order Book: A list of buy and sell orders for a security, organized by price. Its fragility can lead to rapid price changes.

The Risk of Legging Into Spreads

This discussion centers around the inherent risks associated with “legging into” options spreads, specifically vertical spreads, compared to executing them as a single transaction. The core argument presented is that legging in introduces unnecessary risk and reduces the probability of achieving the desired outcome.

Understanding the Problem: The Broomstick Analogy

To illustrate the concept, the speakers use an analogy involving cutting a broomstick. Cutting the stick into two pieces represents entering the two legs of a vertical spread separately. The key takeaway is that when entering a spread as a single transaction, you specify a net debit (the total cost of the spread). This is one choice. However, when legging in, you are essentially giving the market the freedom to determine the price of the second leg, introducing uncertainty.

• One Choice vs. Multiple Choices: When specifying a net debit, the market can fill the order in an infinite number of ways to achieve that price. Legging in forces a specific price for the second leg, limiting flexibility.
• Degrees of Freedom: Entering the spread as a single transaction has one degree of freedom (the desired net debit). Legging in introduces a second degree of freedom, increasing the potential for unfavorable outcomes.
• Mathematical Illustration: The speakers demonstrate that the number of possible outcomes increases dramatically when entering legs separately (from 31 possibilities with one degree of freedom to 3721 with two).

Execution Risk and Market Dynamics

The primary risk identified is execution risk. By legging in, traders expose themselves to the possibility of the second leg being filled at a less favorable price than anticipated.

• Market Volatility: Even a small price movement in the underlying asset or a change in implied volatility between the time the first leg is executed and the time the second leg is executed can significantly impact the overall cost of the spread.
• Limit Order Book Fragility: The speakers emphasize that limit order books can be fragile. A single trade can quickly move prices, making it difficult to get the desired fill on the second leg.
• The Delta of the Spread: The combined delta of a vertical spread is more stable than the deltas of the individual legs. Entering the spread as a single transaction leverages this stability.

Real-World Examples and Scenarios

The discussion includes several scenarios to illustrate the risks:

• The Car Dealership Analogy: Negotiating a car deal is used to demonstrate the importance of focusing on the net price rather than getting caught up in the individual components. Similarly, traders should focus on the net debit of the spread, not the individual prices of the legs.
• Murphy’s Law: The speakers highlight the tendency for unfavorable events to occur when legging in. For example, the underlying asset might rally after the first leg is executed, forcing the trader to pay a higher price for the second leg.
• The Stock Ticking Up: A specific example is given where the stock price increases between the execution of the first and second legs, resulting in a higher net debit than intended.

Key Arguments and Perspectives

• Professional Traders Avoid Legging In: The speakers repeatedly emphasize that professional traders avoid legging in because they understand the inherent risks.
• Focus on the Net Debit: The core message is to focus on the desired net debit of the spread and execute the trade as a single transaction to minimize execution risk.
• Don't Give Control to the Market: Legging in gives the market the opportunity to dictate the price of the second leg, reducing the trader's control.

Notable Quotes

• “Execution risk is something that a lot of people don't even think about.” – Bill Johnson
• “You’re giving the market the choice to make that second cut.” – Bill Johnson
• “Don’t give control that you have and you’re giving it away to randomness.” – Stu

Upcoming Event: Market Rebellion Conference

The speakers promote an upcoming conference in Miami on January 29th and 30th, where they will delve deeper into these topics and discuss the differences between retail and professional trading strategies. A QR code is provided for access to a virtual pass.

Conclusion

The central takeaway is that legging into vertical spreads introduces unnecessary risk and reduces the probability of achieving the desired outcome. By executing the spread as a single transaction and focusing on the net debit, traders can minimize execution risk and improve their chances of success. The detailed mathematical explanation and real-world examples provide a compelling argument for this approach, highlighting the importance of understanding the underlying mechanics of options trading.