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Multi-Leg Options Can Reduce Risk & Improve Executions

Tony Zhang
November 3, 2021
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10 minutes read
Multi-Leg Options Can Reduce Risk & Improve Executions

Trading options involves selecting from a world of options, which may seem overwhelming at first. With 4 core strategies, buying calls, selling calls, buying puts and selling puts, it’s already a step up in complexity from stock investing and trading. Despite the flexibility that these strategies provide, each has their benefits and drawbacks. In this post, I will dive into the drawbacks of each strategy and how we can seek to minimize them by combining the four core strategies into multi-leg options strategies. We will seek to improve probabilities of success, reduce risks and even improve execution quality.

Buying Options

When we buy an option, they are by design, a limited risk instrument which allow investors to gain substantial upside exposure to a security but limit the maximum risk to the amount paid for the option contract. This may sound tempting, but the primary issue with buying options is that they are generally quite efficiently priced. The price paid for the options already reflects the expected move of the underlying security, considering the time to expiration and the expected volatility. This means, to profit from buying an option, not only do you need to get the direction correct, but the underlying security will also need to exceed the market’s expected volatility. For this reason, buying an outright call or a put option has a lower probability of success despite the theoretically unlimited profit potential.

Selling Options

On the other hand, selling an option has the exact opposite risk profile. In exchange for an upfront payment, the option seller takes on the obligation to buy/sell the stock to the buyer of the option at any time up to expiration at the agreed upon price. This obligation has significant risk. If the asset moves significantly against the expected trading range and direction, the risk is unlimited. In exchange for taking on this risk, the selling is compensated based on the market’s expected volatility. While this strategy has a very high probability of success, its poor potential risk/reward and unlimited risk nature makes it unsuitable for many investors.

What are Multi-Leg Options Strategies?

Multi-leg option strategies involve using two or more options in a single strategy and order. This combination of buying/selling call/put options at the same time allows for additional flexibility in the risk and rewards of each single leg strategy. They can allow for a more balanced risk profile and do not force investors to either take on unlimited risk, or a low probability of success. This is done by either reducing the cost to enter the trade or reducing the maximum risk or margin required to enter the trade. With this more balanced risk-profile, there are some tradeoffs as well, however, investors can seek strategies that have both limited risk and limited reward, without having to choose between the two.

Advantages of Multi-Leg Strategies

The benefits of utilizing multi-leg strategies are different for option buyers and option sellers. Multi-leg strategies allow option buyers to reduce the initial cost of the trade. This firstly reduces the total risk of the trade, but more importantly, increases the probability of success due to a reduced breakeven cost on the trade. For options sellers, multi-leg options strategies will significantly reduce the maximum risk and reduce the margin required to sell an option. In the example of selling a put option, the maximum risk per share is the strike price of the options contract minus the premium received and will be realized if the security declines to zero. Using a multi-leg strategy allows investors to limit the maximum risk and reduce the margin requirement of selling a naked call or put.

Table 1: Multi-Leg Options Benefits

Source: OptionsPlay

 

How can Multi-Leg Options improve my order execution?

From an execution perspective, multi-leg orders allow investors to eliminate execution risk of entering two separate trades to create a spread. If each leg’s orders are entered separately as two trades, there is a risk of one leg being executed while the other does not at the same time or at all. This creates an unbalanced position as the underlying stock can move significantly in the time it takes for the second order to get filled. Multi-leg orders ensure that both legs get filled at a single price and guarantees execution on both sides, thus eliminating an unbalanced position.
Additionally, multi-leg orders typically offer a better probability of execution at a fair price versus a single leg option. For the same reasons that multi-leg positions have reduced risk to the investor, a market maker who is creating liquidity on the trade also experiences reduced risks, and generally will be more willing to take on a multi-leg order over a single leg. In my experience of trading, market makers will typically execute a multi-leg order closer to the midpoint (fair value) than a single leg.

Summary

Using multi-leg option strategies allows for you to seek a more balanced risk to reward profile. This primary advantage comes from not being forced to either take on unlimited risk or unlimited reward, both of which have drawbacks. Whether you prefer to buy options to speculate on the directional view of an asset or sell an option to collect premium, multi-leg options strategies can help you reduce your overall risk. In addition, due to the defined risk nature of some multi-leg strategies, a reduction in margin requirements will provide capital efficiencies to your portfolio. Lastly, multi-leg options will eliminate unbalanced execution risk while also improving your probability of receiving an execution at a fair price.

Take advantage of free access to OptionsPlay Canada: www.optionsplay.com/tmx

 

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Copyright © 2021 Bourse de Montreal Inc. All rights reserved. Do not copy, distribute, sell or modify this document without Montreal Exchange’s prior written consent. This information is provided for information purposes only. The views, opinions and advice provided in this article reflect those of the individual author. This article is not endorsed by TMX Group or its affiliated companies. Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the information contained in this article, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information. This article is not intended to provide legal, accounting, tax, investment, financial or other advice and should not be relied upon for such advice. The information provided is not an invitation to purchase securities listed on Toronto Stock Exchange, TSX Venture Exchange and/or Montreal Exchange. TMX Group and its affiliated companies do not endorse or recommend any securities referenced in this publication. Toronto Stock Exchange, TSX, TMX, the TMX design, The Future is Yours to See., and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc. and are used under license. Montreal Exchange and MX are the trademarks of Bourse de Montréal Inc. All other trademarks used herein are the property of their respective owners.

Tony Zhang
Tony Zhang http://tmx.optionsplay.com

Head of Product Strategy for OptionsPlay

OptionsPlay

Tony Zhang is a specialist in the financial services industry with over a decade of experience spanning product development, research and market strategist roles across equities, foreign exchange and derivatives. As the current Head of Product Strategy for OptionsPlay, Tony leads the research and development of their OptionsPlay Ideas & Portfolio platform. He has leveraged his interest in financial technology and product development to provide innovative, reimagined solutions to clients and the users they seek to serve. Previously he spent 7 years at FOREX.com with a capital markets and research background as a market strategist specializing in equity and FX derivatives markets.

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