Do You Trade Spreads? Here’s Why You Should Consider Legging Into Them…

Charles Cottle’s column is intended for more advanced traders. If you would like to learn how Mr. Cottle trades, you can find more information here.

It was once considered sound advice not to leg into and/or out of an options spread. Most investors still shy away from doing this and put all their orders in as spreads. It was good advice when orders were physically handled in the pits on the options floors around the country and one had very little control when transacting. Levels of frustration run high when people are waiting for information about impending fills, canceled orders or even a simple quote. The world has changed and immediate gratification has become more attainable. Options can be clicked into and out of in a matter of seconds and therefore the transaction risk has been greatly diminished. There are a couple of nuances of the options market that we advise to keep in mind when legging, especially when ‘caught naked between spread legs’.

1. In an electronic world, one gains control by legging spreads, avoiding floor procedures at all costs.

2. One needs to understand synthetic relationship in order to have other ways in or out of a position.

3. Save money while still motivating market makers to take the other side of your orders.

4. One should not be afraid to use stock to ‘stop the bleeding’ (or at least change the flow of blood).

From a margin and risk standpoint it is prudent to leg the buy side first but if you have the wherewithal, by all means, go ahead and leg from the short side. Having said that, it may be inconsistent with your market opinion and you might want to consider executing the synthetic equivalent position as an alternative, i.e. when bearish buy a put vertical (bear spread) instead of selling a call vertical (also bear spread). When at the same strikes, the synthetic equivalents move at about the same rate and maintain a fairly constant relationship (called the “box”). It’s also wise to consider that the out-of-the-money synthetic equivalent options’ bid/ask spreads can be considerably narrower reducing the cost of doing business.

Do the hard side first. One leg of the spread can be considered harder than the other side when there is lower liquidity in one of the components. To help determine the level of liquidity, check the volume and open interest and make sure that there is some trading going on in those options. Note the widths of the individual markets in order to indicate what you might be faced with when trying to make subsequent adjustments or liquidating the trade. For calendar spreads (also known as time spreads) the hard side would almost certainly mean trading the deferred month first and then the closer dated month. The front month moves faster (higher gamma) but the options are usually more liquid. There are those, more experienced ‘leggers’ who prefer to enter their buys and sells to work at the same time but that is not recommended for everyone. Either way on may prepare orders and store them in the “Order Queue” ready for sending.

For a Ratio/Back (ShortMore/LongMore) spread, I like to grab the greater quantity side first. It is easier to pull the trigger on the smaller quantity especially if it starts to get away

Let’s say that you have Long 10 March 90/95 call spreads (bull spreads), when you are long 10 Mar 90C and short 10 Mar 95C and want to liquidate it (with a bear spread). On the natural markets, the spread is 3.60 (bid) – (at) 4.00 which is 40 cents wide. It’s a pretty good bet that the spread is worth about 3.80 when 3.80 is the current average between bid and offer. The inside or actual market would be something like 3.70 – 3.90 or possibly even 3.75 – 3.85 if the crowd felt that they had to be a bit more competitive with one another or the other exchanges. By the way, the 3.60 bid is derived from 8.60, the bid price of the 90s, minus 5.00, the offer price of the 95s).

The 4.00 offer price is derived from 8.80, the offer price of the 90s, minus 4.80, the bid price of the 95s. Incidentally, one should always consider the corresponding put spread and in this case the Mar 90/95 put spread is 1.05 – 1.35, only 30 cents wide on the naturals and most likely something like 1.15 – 1.25 when the fair value is 1.20. The 1.05 bid is derived from 2.20, the bid price of the 95s, minus 1.15, the offer price of the 90s. The 1.35 offer is derived from 2.35, the offer price of the 95s, minus 1.00, the bid price of the 90s. Very seldom does one have to “pay up” to “take” the natural offer or “sell down” to “hit” the natural bid. Often traders like to middle the market in hopes that the market will move to their price. The market would almost certainly have to move because there is little incentive for market makers to meet in the middle unless the trade happens to fit their position. It is rare, indeed, that a market maker meets in the middle since the reason they come to work is to buy under-value and sell over-value. A current offer at the middle, i.e., 3.80 would prove fruitless temporarily but could get bought in the event of a market rally enough to motivate a market maker to buy it. The spread happens to have a delta of about .20 so a 50-cent rally in the stock may increase the spread’s value by about10 cents meaning that it would then be worth 3.90 making the 3.80 a better buy so the offer may be scooped up.

Back to the trade – remember, we are through with being bullish, or we are now bearish, or we have enough profit, and now we want out. From a market opinion standpoint it doesn’t make sense to leg by buying our short 95 calls back first. It may also be prohibitive from a risk and margin standpoint to sell out our long 90 calls because that would leave us naked short the 95s. What oh what can we do? Buy the 90/95 put spread (some call it the 95/90 put spread) instead. If we get filled, we will be long the 90/95box. It may be necessary to sell the box later due to the pin risk ¹ potentially involved.

(don’t worry, the box can usually be sold just prior to expiration for a nickel or two less than the 5.00 value). It is reasonable to assume that if we bid 2.30 for the 95 puts (just a nickel away from the ask of 2.35), we would get filled then by offering the 90 puts at 1.05 (only a nickel away from the 1.00 bid). The net price of 1.25 for the spread is synthetically equivalent to selling the call spread for 3.75 when the box is worth around 5.00 ² . Not bad.

What if you wanted to just get long 10 put spreads, and you intended to buy it at about 1.25. That would be $1250 of risk. Therefore, when legging you should not risk more than that amount (assume the worst). This means that you buy about 5 contracts at a price of 2.30 on the first leg, get filled and get filled on the other side’s sale before going for the next set of fives. Legging 5 at a time instead of legging all 10 at once ($2300) will end up costing a bit more in commissions depending on thicket charge if your broker charges them. The immediate accomplishment, along with the fact that you are more assured of getting in or out of the market, will make it well worthwhile. Remember also that the reason you are legging in the first place is to get a fill at possibly a better price. Better prices for your spreads will save more than the extra commissions spent.

1 Pin Risk is discussed in Coulda Woulda Shoulda starting on page 75.

2 Actually a box is worth the present value between the strikes with some exceptions. See more about boxes in Chapter 8 of Coulda Woulda Shoulda, starting on page 169.

Charles Cottle