Advanced Strategy: Legging into Spreads and Width Adjustments
The Black Book of Day Trading Strategies
1,000 complete strategies · 31 chapters · Full trade plans
Once a trader has mastered the fundamentals of credit spreads, they can begin to explore more advanced strategies for constructing and managing their positions. Two such strategies are legging into spreads and adjusting the width of the spread. This article will provide an overview of these advanced techniques and discuss their potential benefits and risks.
Legging into Spreads
Legging into a spread involves entering the position one leg at a time, rather than simultaneously. For a credit spread, this would typically involve selling the short option first and then buying the long option at a later time. The goal of this strategy is to improve the credit received for the spread.
For example, a trader might sell a put option when they believe that the underlying asset is at a short-term peak. They would then wait for the underlying asset to fall before buying the long put option. This would allow them to buy the long put at a lower price, which would increase the net credit received for the spread.
However, legging into a spread is a risky strategy. If the underlying asset moves against the trader after they have entered the short leg, they could be forced to buy the long leg at a much higher price, which would reduce the credit received or even result in a net debit.
Adjusting Spread Width
Adjusting the width of a spread involves closing the existing long option and opening a new long option with a different strike price. This can be done to either increase or decrease the width of the spread.
- Increasing Spread Width: A trader might increase the width of a spread if they believe that the underlying asset is likely to move further in their favor. This would increase the potential profit of the trade, but it would also increase the potential loss.
- Decreasing Spread Width: A trader might decrease the width of a spread if they believe that the underlying asset is likely to become more volatile. This would decrease the potential loss of the trade, but it would also decrease the potential profit.
Data Table: Legging into a Bull Put Spread
Let's consider a bull put spread on a stock trading at $100. A trader sells a put option with a strike price of $95 for a premium of $1.50. They then wait for the stock to fall to $98 before buying a put option with a strike price of $90 for a premium of $0.80.
| Action | Stock Price | Option | Premium | Net Credit |
|---|---|---|---|---|
| Sell Short Put | $100 | $95 Put | $1.50 | $1.50 |
| Buy Long Put | $98 | $90 Put | $0.80 | $0.70 |
In this example, the trader was able to increase the net credit received for the spread by legging into the position. However, if the stock had continued to rise after they sold the short put, they would have been forced to buy the long put at a higher price, which would have reduced their profit.
The Kelly Criterion and Position Sizing
When employing advanced strategies such as legging into spreads, it is important to have a disciplined approach to position sizing. The Kelly Criterion is a mathematical formula that can be used to determine the optimal size of a position based on the probability of success and the expected return.
The formula is as follows:
Kelly % = W - [(1 - W) / R]
Where:
- W = Probability of winning
- R = Win/loss ratio
By using the Kelly Criterion, a trader can avoid over-leveraging their account and ensure that they are not taking on an excessive amount of risk.
Actionable Example
A professional trader might use a legging-in strategy when they have a strong conviction in a directional move but are not yet confident enough to enter the full spread. They might sell the short option first and then set a limit order to buy the long option at a more favorable price.
This requires a high level of skill and discipline, as well as a deep understanding of market dynamics. It is not a strategy for novice traders.
In conclusion, legging into spreads and adjusting the width of the spread are two advanced strategies that can be used to enhance the profitability of a credit spread trading strategy. However, these strategies are not without risk, and they should only be used by experienced traders who have a deep understanding of the market and a disciplined approach to risk management.