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Trying to get a leg up on the market when entering spreads?

There are some traders who “leg in” and “leg out” of spread trades. That means buying the components of the spread as individual transaction.

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For example, if you wanted to sell a put spread (this is where you sell a put closer to the money and buy a put further out of the money for a net credit to you) you would try to buy the long put when the stock was at a relative high point – and thus at lower cost – and then sell the long put when the stock was at a relative low point – and thus at a higher credit. In theory, the net would mean more credit to you.

In my experience, that is about as successful as trying to find the Leprechaun and his Pot ‘O Gold at the end of the Rainbow.

Legging in for an edge does not work. It’s tantamount to day-trading. You are trying to time the market. I think you’d be lucky to be right 50% of the time. Day-traders may take offense to this. But, in my experience the profitable day-trader is the Sasquatch of the trading world. Even if that Sasquatch does exist, a sighting is very rare.

While I do “leg in” and “leg out” of trades, its not for a cost benefit. I do it as an adjustment, to account for my change in sentiment.

Why do your trades show a loss when you enter them? Since we sell at the Bid and buy at the Ask price, you have to look at that as a loss as soon as you enter a transaction.

This is why it’s important for you to consider equities with decent liquidity. For example, if you look at the SPY. You might find a Bid/Ask of one or two pennies. If the option was Ask at $1.00 and Bid at $0.98 (a $0.02 Bid/Ask), you just lost 2% if you exited your trade immediately.

However, if the Bid/Ask was wide. Let’s say the Bid/Ask was $0.25 (Bid $0.75 and Ask $1.00.) Your would lose 25% if you closed the trade immediately. The actual market might be closer to the middle of the Bid/Ask. Market Makers claim that they keep the Bid/Ask wide so that they do not get abused by large institutional investors. However, I think that retail investors are the ones who end up getting abused. You might find out that you can get in at a favorable price and then when you try to get out, the Bid/Ask mysteriously moves against you. Call me paranoid. But, it’s uncanny when that happens.

It’s also worth noting that some brokers calculate your P&L differently. Do they use the Bid or Ask? Do they use the last transaction price? Do they use the “mid” price? Each could make a difference in your apparent P&L statement. The truth is that they should use the actual market price and you won’t know that until you put an order to market or someone else does.

This is why it’s important to consider higher liquidity equities – not just the equity liquidity, but the option liquidity too. For example DECK and VAL are companies that I would like to trade. But, there is not enough liquidity in the options. If I am going to give up 15% or 20% just to the Bid/Ask spread, it’s going to be very difficult to make a profit. For equities like that, you need to be right with your first trade and hope that it doesn’t require adjustment.

For me, “hope” is an alarm. When I find “hope” working its way into my trading plan, I know that it’s a bad trading plan and I don’t do it.

If you want to leg into a spread to try to get an edge, you’re only hope is to time the market: buy on the dip and sell on the tops.

And there’s that word: hope. The bottom line is that there is no way to “cheat” the market. My suggestion is stick with highly liquid equities and enter your price at the “mid.” You can adjust to seek your price from there.

…And let me know if you spot Sasquatch.

Eric Hale
OptionsANIMAL Instructor

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