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Earning profits in the stock market is a strategic game. Despite the fluctuating prices and uncertainty, one can make significant profits provided there is a calculated strategy. The market has various tools and techniques to help traders analyse trends and mitigate risks.
One such tool is the options contract. In an options trade, the holder can cancel the contract if the market situation is unfavourable. Though the purpose of it is to hedge risk, most options traders incur losses, defeating the objective of such contracts. This is because of insufficient knowledge and clarity on options trading and strategies.
In today’s article, we will discuss thoroughly the multi-leg order strategy used by options traders when the market is uncertain.
What is a multi-leg order?
Multi-leg order is an options strategy with multiple contracts.
In a regular options contract, a trader can choose between call and put based on the market’s direction and the trader’s perspective. However, in a multi-leg options order, a trader enters into a combination of these contracts. Some multi-leg orders have two contracts with one call and one put, while others may have four contracts with two calls and two puts.
How does the multi-leg order work?
Multi-leg orders are ideal when the market is indecisive. It is where the market is volatile, but there is no dominant trend. Since the direction is uncertain, deciding entry and exit positions can be challenging for traders. That is where entering into multiple options contracts with the multi-leg order is helpful.
In a multi-leg order, options traders enter into a combination of calls and put options on the same asset, usually with different strike prices, expiring on the same date. So, the trader is covered whether the prices move up or down.
Before the multi-leg order system gained popularity, traders had to place each leg in a separate order. This not only increased the time but also the cost since each trade placed would involve brokerage and other associated costs. The possibility of delays in placing the consequent legs was also high, leading to losses and missed opportunities. But, with the multi-leg order system coming in, it is now simpler to place multiple legs of the trade simultaneously. It saves time and costs, besides eliminating the risk of delays for traders.
Multi-leg options order example
Take the example of Mr A, a trader who enters into a multi-leg options order. The stocks of Company ABC are currently trading at ₹100. He sees that the prices are volatile but is unsure of how they will move in the days to come. So, to profit from the fluctuation, he enters the below contracts.
- Call: Strike price @ ₹105
- Put: Strike price @ ₹95
If the price increases to ₹115, he exercises the call option and makes a profit. The put option will, however, expire, and the premium is the trader’s loss.
If the stock decreases to ₹90, he exercises the put option and lets the call option expire. The loss is again limited to the cost of the call option.
So, irrespective of the direction, Trader A is covered. However, if the price stays between ₹105 and ₹95, both contracts lose their value. Hence, choosing the right strike price is essential for the success of an options contract.
Some popular multi-leg option strategies
- Iron condor – The trader enters into four different contracts lapsing together with different strike prices. The strategy consists of buying a call option and a put option and selling a call option and a put option. The strike price of each leg relies on the bullish or bearish approach of the trader.
- Iron butterfly – Iron butterfly also involves four contracts expiring together. The trader purchases a call and a put, along with selling a call and a put. However, both the call and put contracts sold by the trader will have the same strike price. This is ideal when the price is not highly volatile and is moving within a short range.
- Straddle – This is a simple multi-leg order involving two contracts. Traders either buy a call and put (Long straddle) or sell a call and put (Short straddle) based on their perspective of the market. The strike prices and the expiration of both contracts are the same for a straddle.
- Strangle – It is another multi-leg order involving two contracts like the straddle, but with different strike prices and the same expiry date.
Bottomline
Multi-leg orders are options involving two or more contracts on the same asset, placed simultaneously. It helps options traders in a market where the direction of the stock’s price is uncertain.
Being a successful options trader requires a thorough understanding of various strategies, including multi-leg orders. Accuracy in choosing the strike price for each leg is the key to profits in a multi-leg order.
FAQs
Options are contracts that give traders the right to either exercise the trade or cancel it depending on the market’s condition. Since it allows traders to cancel trades in unfavourable circumstances, the risk of losses is hedged.
Indecision in the stock market is a situation where no trend is dominant. Both bulls and bears fight with each other to turn the market into up and downtrends, respectively. However, they fail to take control leading to the market moving sideways.
A two-leg options strategy involves two options contracts. It is usually a combination of traders going long or short on put and call options. The mixture is based on the market’s trend and the trader’s approach.
A four-leg options strategy involves entering into four options contracts on the same asset. These are usually complex and require thorough skills, as choosing the wrong contracts can cause significant losses.
Legging risk is the risk of price fluctuations in between placing different legs of an order. Such fluctuations can disrupt the trader’s strategy, leading to losses. The multi-leg order system has now mitigated the risk by allowing traders to place all the legs of the order at once
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