What is a leg?
A leg is part of a derivative trading strategy in which a trader combines multiple option contracts, futures or, in rare cases, combinations of the two to hedge a position, benefit from arbitrage or take advantage of a spread. In these strategies, each derivative contract or position in the underlying security is called a leg. The cash flows exchanged under a swap are also called legs.
The basics of a leg
A leg is a part or side of a multi-step trade. These types of trades are like a long trip race – they have multiple parts or legs. They are used in place of individual trades, especially when the trades require more complex strategies. A step may include the simultaneous purchase and sale of a security.
In order for the legs to work, it is important to consider the timing. The legs must be exercised at the same time in order to avoid any risk linked to fluctuations in the price of the corresponding security. A purchase and a sale must therefore be made at approximately the same time to avoid any price risk.
There are several facets to the legs, which are described below.
Options are derivative contracts that give traders the right, but not the obligation, to buy or sell the underlying security at an agreed price – also called the strike price – by a certain date at the latest. ‘expiry. During a purchase, a trader launches a purchase option. When he sells, it is a put option.
The simplest option strategies are simple and involve a single contract. These come in four basic forms:
|Long call (buy purchase option)||Short call (sell or “write” a call option)|
|Short put (sell or “write” a put option)||Long put (buy put option)|
A fifth form – the guaranteed cash put – involves selling a put option and keeping the cash on hand to buy the underlying security if the option is exercised.
By combining these options with each other and / or with short or long positions in the underlying securities, traders can build complex bets on future price movements, take advantage of their potential gains, limit their potential losses and even win. free money through arbitrage – the practice of capitalizing on rare market inefficiencies.
Two Legged Strategy: Long Straddle
The long straddle is an example of an option strategy consisting of two legs, a long call and a long put. This strategy is good for traders who know that the price of a security will change but do not know how it will change. The investor breaks even if the price increases by his net debit – the price he paid for the two contracts plus commissions – or if he decreases by his net debit. It profits if it goes further in both directions, otherwise it loses money. Its loss, however, is limited to its net debit.
As the graph below shows, the combination of these two contracts generates a profit, whether the price of the underlying security rises or falls.
Three-legged strategy: collar
The collar is a protection strategy used on a long stock position. It has three legs:
- a long position in the underlying security
- a long bet
- a short call
This combination amounts to a bet that the underlying price will go up, but it is covered by the long term, which limits the potential for loss. This combination alone is known as a protective put. By adding a short call, the investor has limited his potential profit. On the other hand, the money it receives from the sale of the call compensates for the price of the put and may even have exceeded it, thereby reducing its net flow.
This strategy is generally used by traders who are slightly bullish and do not expect sharp price increases.
Four-legged strategy: Iron Condor
The iron condor is a complex, low-risk strategy, but its goal is simple: to make some money by betting that the underlying price will not move much. Ideally, the underlying price at maturity will be between the strike price of the short put and the short call. Profits are capped at the net credit that the investor receives after the purchase and sale of the contracts, but the maximum loss is also limited.
Building this strategy requires four steps or steps. You buy a put, sell a put, buy a call and sell a call at the relative strike prices shown below. Expiration dates must be close to each other, if not identical, and the ideal scenario is that each contract expires without money – that is, without value.
Futures contracts can also be combined, with each contract forming part of a larger strategy. These strategies include calendar spreads, where a trader sells a futures contract for a delivery date and buys a contract for the same product with a different delivery date. The purchase of a contract that expires relatively early and the termination of a subsequent (or “deferred”) contract is bullish, and vice versa.
Other strategies try to take advantage of the difference between the different prices of raw materials, such as the crack difference – the difference between oil and its by-products – or the spark – the difference between the price of natural gas and electricity from gas plants.
Key points to remember
- A leg is part of a multi-step trade.
- A trader will implement steps in his strategy to hedge a position, benefit from arbitrage or take advantage of a spread.
- Legs can be part of a variety of strategies, including a long straddle, a collar, and an iron condor.