Why Legging Out Could Impact Potential Strangle Returns

Key Concepts

Legging In/Out: Managing individual legs (options) of a multi-leg options strategy independently, rather than closing the entire position at once.
Credit Spread: An options strategy involving selling an option and buying another option of the same type (call or put) with a different strike price, creating a net credit.
Iron Condor: A neutral options strategy that combines a bull put spread and a bear call spread, aiming to profit from low volatility.
Strangle: An options strategy that involves selling an out-of-the-money (OTM) put and an OTM call with the same expiration date.
Delta: A measure of an option's price sensitivity to a $1 change in the underlying asset's price.
Max Profit: The maximum potential profit of an options strategy.
Debit Paid: The cost incurred when buying an option or closing a leg of a strategy.
Win Rate: The percentage of trades that result in a profit.
Volatility: The degree of variation of a trading price series over time.

Analysis of Legging In and Out in Options Trading

This discussion explores the concept of "legging in and out" of options trades, particularly in the context of managing multi-leg strategies like strangles, and its impact on risk and reward. The speakers, Mikey and another individual, debate the effectiveness of this approach, especially in the current market environment characterized by increased volatility.

The Risks of Legging

The primary argument against legging in and out is that it can add risk without a commensurate reward. Mikey emphasizes that this is generally true unless specific conditions are met. The exception highlighted is when one side of a credit spread, like an iron condor, is "blown out" and the other side is worthless. In such scenarios, legging out of the profitable side can be a valid risk management technique.

However, for individual equities and broad market ETFs like SPY or Qs, legging out is often not recommended. The "skewed side" (typically the put side in a down market) often holds its value, making it less advantageous to close it prematurely. The main issues with legging arise from spreads and when traders attempt to "leg in" by selling a put into a down move and a call into an up move, which can be problematic.

Market Environment and Trading Strategies

The market has been trading in a wide range since 20125, with increased volatility observed in October. This has prompted traders to be more aggressive in managing their positions, especially those that move quickly. The speakers advocate for taking profits and legging out of positions into huge moves if a significant portion of the profit has been realized. This year has been described as a "trader market," where managing risk effectively by removing profits quickly is beneficial.

Study on SPY Strangle Management

A study was conducted analyzing the performance of selling SPY 16 delta, 45-day strangles over the last 10 years. The study compared two management approaches:

Managing the entire trade at 50% of max profit.
Managing each leg (put and call) independently at 50% of max profit.

The study focused on SPY, an ETF that typically exhibits less dramatic price movements compared to individual equities. This means that trades on SPY do not experience the same rapid decay or explosive moves as seen in individual stocks.

Increased Market Volatility

Recent data indicates a significant increase in market volatility. In the past 10 months leading up to October, the average daily price movement has increased by 2.4x, and the daily percentage change has increased by 1.5x compared to the 2015-2014 period. The daily dollar move is wider due to the overall growth of the stock market. Percentage-wise, the daily change has moved from approximately 0.5% to 0.9%. This contrasts with earlier years (2015-2018) where the market experienced very low volatility, making trading a "grind." The current environment offers more "two-sided action," which is beneficial for traders.

The Rationale Behind Legging

Traders consider legging in and out to time the market and take advantage of volatility, aiming for more frequent winners with shorter holding periods. This approach is particularly considered for smaller accounts where gaining directional exposure can be challenging. For instance, closing out profitable puts can synthetically create short delta exposure without initiating a new short delta position, which is crucial when capital is limited.

Study Findings: Legging vs. Whole Position Management

The study's analysis revealed that legging approaches did not improve performance. In fact, managing the whole position slightly outperformed legging out over the long term.

Increased Losses: Legging out at 50% of profit resulted in larger losses. This is because buying back an option at 50% of its value still leaves a significant portion of its worth. The debit paid to close one leg is added risk to the remaining leg. For example, buying back puts in a down move adds risk to the upside.
Decreased Average P&L: The average profit and loss (P&L) decreased when legging out.
Lower Win Rate: The win rate also declined, attributed to the cost of buying back premium.

The core issue is that 50% of the value is still a substantial amount of the option's worth, especially in less volatile instruments like ETFs.

Key Takeaways and Recommendations

Increased Complexity and Risk: Legging in and out increases portfolio management complexity and exposes traders to more directional risk, particularly in instruments like SPY.
Superior Strategy: Managing strangles as a whole position is a more effective strategy than managing each side independently.
Strategic Risk Removal: If legging out is considered, it should be done to remove "cheap risk wherever it is." The speakers prefer to view this as "taking risk off" rather than a specific "legging out" strategy.
Debit Trade Management: Debit trades with unlimited profit potential are harder to manage. Short premium trades offer defined risk.
Profit Extraction: The more profit you have on the table, the less you can make going forward, while still holding all the risk.
Iron Condor Legging: For iron condors, legging out is more justifiable when aiming for 75-80-90% of the value, as at that point, there's little reason to keep the position open. However, legging out at 50% is considered debatable.