Many traders have bought a put or a call option. It’s a straightforward options strategy. If you believe a stock is going up, you buy a call. If you believe it is going down, you buy a put. Gains are unlimited, but the risk is high since the entire amount paid for the option can be lost.
But what if you had a way to clearly define your maximum downside risk and even adjust it? For this added benefit, you’d have to give up some upside. It would no longer be unlimited.
You can achieve this through multi-leg options strategies. In this article, we’ll go over what multi-legged options configuration is and why it can be useful when options trading.
What Is A Single-Leg Options Configuration?
A single-leg options strategy uses one option contract to open a position. Most single-leg positions are directional. In other words, the market needs to move up or down for the position to make money.
Even then, some single-leg positions may not make anything. It just depends on how far the market moves above or below the strike price, depending if the option is a call or put.
Single-leg strategies can be risky since the entire amount paid for the option can be lost. There’s little room for margin of error. Although if a trader believes their position isn’t going to be profitable, they can close it out sooner, losing less in the process.
Related: Analyzing And Trading Options 101
What Is A Multi-Leg Options Configuration?
Multi-leg options strategies utilize more than one option to create a position. When we talk about an option leg, it means an option contract that is taken out at the same time as one or more other contracts to build one position.
A multi-leg spread could consist of selling the WMT, July 16, 135 call and buying the WMT, July 16 130 call. Or, it might go diagonal, in which different expiration dates are used. For example, you could sell the WMT, July 09, 135 call and buy the WMT, July 16, 130 call. Those two options expire at different times.
Both of the above strategies use two legs (i.e. the position consists of two options). More options can be added, but you need to keep the legs in sync. The first spread strategy uses one option per leg. The number of positions is one even though it has two underlying contracts.
Pros And Cons Of Multi-Leg Options Trades
Multi-leg options strategies are more
complex. However, many of the best options platforms provide templates for setting up various multi-leg options configurations. This removes some of the complexity, but it can still be easy to mess up the configuration.
For example, let's say you set up a four option Iron Condor. This means four positions of the Iron Condor. A single Iron Condor requires four contracts. So the total for these four positions is 4 x 4 = 16 contracts. But while setting up the trade, you accidentally delete two of the contracts. Now the Iron Condor is misconfigured.
Some platforms will point out the misconfiguration, but others will allow you to continue putting in the trade. If you don’t catch the mistake, you could end up in a position you never intended to execute.
Contracts fees are higher with multi-leg strategies as well. Options commissions went away with stock commissions. However, most commission-free stock brokers still charge a per-contract fee which is often between $0.35 - $0.65 per options contract. Because each multi-leg position requires more contracts, your total contract fee will be higher which will eat into profits.
One of the biggest advantages of multi-leg strategies is that you can limit downside risk. Rather than losing all capital in the position, you can create a downside limit (this will limit the upside as well). Because of this defined risk, they require less capital than other (single-leg or equities) strategies that have a similar goal.
There’s also lots of flexibility in how you can configure multi-leg options strategies. Depending on the strikes and expirations chosen, downside risk and upside gain can all be adjusted.
Examples Of Multi-Leg Options Strategies
There are lots of multi-leg strategies available to options traders. We’ll go through just a handful of them to give you an idea of why a trader might use these strategies.
An Iron Condor involves four contracts. It is used when the stock price is expected to move very little. The contracts basically surround the stock price with two above and two below the current price. They can be adjusted closer or further away from the price.
The position is opened by:
- Buying a put with strike A — below B
- Selling a put with strike B — below stock price
- Selling a call with strike C — above stock price
- Buying a call with strike D — above C
The maximum loss is the difference between A and B or C and D, less any net credit received for selling the strategy. A/B is the same distance apart as C/D.
The maximum profit is the net credit from selling B and C. If the stock is between B and C by expiration, you keep the full premium.
This strategy needs the stock price to move by the amount paid for each of the two options. It’s also one of the few multi-leg options strategies with unlimited gain.
You can also lose the entire amount paid for the options, just like you can with single-leg options strategies. But as mentioned previously, there’s more flexibility with a multi-leg strategy and not as much capital is required.
You can open a Long Straddle by:
- Buying a call with strike A
- Buying a put with strike A
Both options will have the same expiration. Strike A is basically the current stock price. If you paid $2 for each option, the stock price will need to move by $4 up or down from the strike.
The maximum loss is the amount paid for both options. If the stock is at the strike by expiration, you’ll lose the amount paid for the options. The maximum profit is unlimited. The gain has a 1:1 ratio with the stock price movement.
Similar to a Long Straddle, the Long Strangle buys two options with the same expiration but different strikes. These two strikes are above and below the current stock price. The stock will need to move further from its current price to make money, compared to the straddle.
Because the strangle requires a large move in the stock price, it may be best used around risk events such as earnings. It doesn’t matter which direction the stock moves.
Opening a strangle involves:
- Buying a put with strike A — below stock price
- Buying a call with strike B — above stock price
To make money, the stock price needs to move below strike A or above strike B. Once it does, the strategy is basically a 1:1 gain with the stock’s price movement.
The maximum loss occurs if the stock price is caught between the two strikes. In that case, the trader will lose the amount paid for the options.
If multi-leg strategies seem complex, but you’d still like to try them without using real money, you can always paper trade. Almost every major platform offer paper trading accounts. And many allow you to practice trading multi-leg options.
Or if you feel like you're ready to start executing multi-leg options strategies live, check out our favorite brokers for options trading.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared toward anyone wanting to earn more, get out of debt, and start building wealth for the future.