# The perils of legging a bull call spread: myth or fact?



## Fox (17 October 2009)

I used to be paranoid about legging in the two legs of a bull call spread. My fear was that prices may move against me in the intervening period between trading both legs. So my view then was that buying both legs as a spread order was superior because:

1. Avoids the risk that prices move against you.
2. MMs give you a better price if the bull call was purchased as a spread order.

Lately, I have not been too sure about point (2). The MM did not seem to bite unless the price was much more favourable to him/her. That got me thinking about point (1) ie. is the fear of prices moving against you warranted?

I started a little spreadsheet with a hypothetical scenario of three possible spot movements:
a. spot moves up a dollar between legs
b. spot does not move between legs
c. spot moves down a dollar between legs.

By transacting the long leg first and then transacting the short leg after the spot moved, (a) was more favourable than buying a spread. (c) was less favourable than buying a spread. As expected (b) is identical to buying a spread.

But what surprised me most was that the gains in (a) far outweigh the losses in (b). This seems to suggest that in the long term, legging should be preferable to buying a spread if you intend to put on a bull call. 

What are your experiences on this issue? In particular, I would be interested to hear your opinions re:
1. MMs give you a better deal if you buy the spread instead of legging.
2. Your views on the long term implications of legging ie. is it better than buying the spread?


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## wayneL (17 October 2009)

Fox,

This is not easy to answer because it depends on what you're trying to achieve with the vertical.

For instance, let's say you want a particular delta exposure, but want a bull call to hog-tie the other Greeks. So you decide on strikes and number of spreads to suit your purpose.

By legging in one side or the other (most would leg the long call first) you are exposing yourself to much more delta than intended. Depending on the final structure, perhaps much much more. *This takes the delta risk (and other greeks) outside of the terms of the intended trade*.

If it goes right, you're a genius. If it goes wrong you beat yourself up and put it in the "You Idiot" file.

If however you want to do some kung-fu metamorphosis trading, sure, leg in, because you're deciding what you want as you go along. But your size will be different because or your intended delta exposure.

If I just want the vertical and that's it, I just trade it as a spread.


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## Grinder (17 October 2009)

Agree with Wayne, depends on what your trying to do. In most cases I would choose not to leg in, if I can get close to my desired price with a spread then theres no need to take the risk by legging. If the market is'nt moving & I want to put on a ratio or slingshot combination then I'll split it to gain the benefit of gamma. In short, the bad fills caused by legging have outweighed the good ones.


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## Fox (18 October 2009)

Fox said:


> ... the gains in (a) far outweigh the losses in (b).



Correction: the line above should read "... the gains in (a) far outweigh the losses in (*c*)"



wayneL said:


> *This takes the delta risk (and other greeks) outside of the terms of the intended trade*.



I must get into the habit of thinking in terms of the greeks. Delta consideration, especially for large sized positions, had not crossed my mind. 



wayneL said:


> ...put it in the "You Idiot" file.



You're sending chills down my spine. I'm still having nightmares over my previous "You Idiot" file entry .



Grinder said:


> If the market isn't moving ...



That's usually where my problem starts. I find myself in a dilemma when I can't get filled for a decent price, while feeling bullish.


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## cutz (18 October 2009)

Hi Fox,

Thanks for bringing up the question, it's always interesting to hear what the pros have to say about this.

With index options i now pretty much execute everything as spreads (except for tweaks) prices are normally fairly tight, i been caught many times before especially with comsec legging it, i cringe looking back on how much i lost in terms of slippage.

With aussie equity options i haven't really explored spreads yet i always do ratios and more often than not quotes aren't shown on the OTM's so i always leg it.

Keep us posted on your findings, i'll be curious to know if i should also be spreading aussie equity options.


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## Fox (18 October 2009)

cutz said:


> With index options i now pretty much execute everything as spreads (except for tweaks) prices are normally fairly tight



I have started dabbling with XJO and found that executing a bull call as a spread is a breeze. The MM is quick to respond and give pretty much what I believe to be fair. As far as XJO is concerned, I don't need to consider legging.



cutz said:


> With aussie equity options i haven't really explored spreads yet ...



That's where I have problems. MMs for even the most liquid equity options demand 2.5c for a 1 contract spread. That is just plain robbery. I'm now considering just playing XJO and abandoning Oz equity options altogether.

That's why I'm interested in finding out the long term impact of legging vs spreading. If MMs continue to demand 2.5c, and the long term average cost of legging is less than 2.5c, then why not leg?


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## cutz (18 October 2009)

Fox said:


> I'm now considering just playing XJO and abandoning Oz equity options altogether.




They certainly are nicer to trade but the problem i'm having at the moment is that they're going for too cheap as a stand alone strategy and looking at long term IV charts they have historically traded for a lot less. 

From my point of view a mix of equity strategies, similar along the lines of what you do but on more expensive series + XJO's with heavy wing protection seem to work OK, although i am finding it harder making money these days. A year ago it was growing on trees, geez i miss extreme vol. 

BTW, be careful if playing with MQG.


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## mazzatelli (19 October 2009)

Maybe its time to add additional arsenal to your repertoire  Dare I say, make a conscious delta bet:couch jk


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## cutz (19 October 2009)

LOL,

The market gives me a beating whenever i have a crack, todays looking cool though.

I'll try to contain my excitement.


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## cutz (21 October 2009)

Hi Guys

Something occurred to me as i was executing a a spread yesterday.

One of the legs was sitting at a nil quoted strike, as i was slowing moving the spread bid up i was also watching that leg move up.

What prevents another retail trader from picking off a leg ?


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## Fox (21 October 2009)

I have seen the same thing as well.

If I recall Sails' previous post correctly, the understanding I have is that the MM handles your spread order. He (or his trading software) decides which legs to put on the market and which legs he will reserve for himself to trade with you. As such, it appears that he (MM) is responsible for the legs in the market. 

As far as you are concerned, either the spread is filled or it is not filled. Whether another retail trader picks off that leg is a matter between the MM and him. That's just my guess or gut feeling for what is going on. 

I am guessing that MMs are heavily assisted by technology ie. software. The software probably dynamically alter prices of the legs according to:

a. market conditions and 
b. his inventory of unhedged positions 

to maximise the probability of a fill, reduce his risk and lock in a profit (for him).

I would be interested to hear from someone who has better insights into how these things work, especially MMs lurking in this forum . I promise not to unleash my flesh eating monkeys if you choose to reveal your trade secrets .


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## cutz (22 October 2009)

Gotcha Fox,

So i guess when i push my spread order through it goes via a market maker before it appears in the market depth unlike a single leg which is straight through, no market maker input.

Explains why i've had complex spreads knocked back.


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## wayneL (22 October 2009)

cutz said:


> Gotcha Fox,
> 
> So i guess when i push my spread order through it goes via a market maker before it appears in the market depth unlike a single leg which is straight through, no market maker input.
> 
> Explains why i've had complex spreads knocked back.




I'm pretty sure this is how it works too. Spread orders never affect bid/ask spreads in the option chain... and you often see inside trades go through without ever appearing in the depth. Obviously these are part of a spread order.


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## Fox (22 October 2009)

cutz said:


> .
> Explains why i've had complex spreads knocked back.



I've had even a basic bull call spread knocked back, twice now. The order was just not acknowledged. If you use TWS, the status colour is light blue. 

I then tried legging and all was fine. This limitation placed by MMs is another case for legging. Sometimes, you just don't have a choice.

If I recall another of Sails' posts, she talked about spreads being placed in a market depth queue. If that was the case, then any retail trader can transact the spread but not the individual legs.

Too bad that TWS does not display the queue of spread orders. I remember watching an OX introduction video that showed that they provided that feature.


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## Fox (23 October 2009)

*An apology to the MM*

I was seething with anger yesterday when I bought a BHP IB using a spread order. By visually inspecting the TWS IV figures dynamically updating throughout the trading it, it appeared that the IV for that day was approximately 28%. I plugged the prices I paid for the 4 legs of my IB and it came out to be about 26%. First reaction was "What a ripoff !". I headed for the flesh eating monkey cage. Time to feed the monkeys with some MM nuts.

Later, I asked myself if I could quantify the amount I was ripped off. I thought of a simple scheme. Firstly, I needed to work out the average IV for each leg. For each leg (eg. $38 put):

I obtained the "course of sales" figures for $38 puts and took a small sample of 5 trades. 
I looked up the "course of sales" figures of the underlying, at the instant when each $38 put option trade was transacted. 
Using this underlying price, I plugged it into Hoadley to calculate the IV of that trade. 
I then took the IVs of all $38 put trades in my sample and averaged it.
I repeated the steps above for the other 3 legs of my IB.

Next I plugged in the average IVs for each leg into Hoadley and worked out how much IB credit I would have received if I had traded each leg with those IV numbers. Let's call this credit amount CREDIT_AVE. 

Let's also call the credit amount I actually received CREDIT_FOX. 

I was almost certain that CREDIT_AVE would be greater than CREDIT_FOX. CREDIT_AVE would be using average IV figures for both buyers and sellers of options. The MM would have profited from both groups and therefore the average IVs should represent the middle ground or true IV. As a retail trader, I would not have been able to surpass the average or true IV.

To my surprise, the CREDIT_FOX was *higher *than CREDIT_AVE. Yes, you read it correctly. It was *higher*. The only possible explanation was that one of the legs was WOTM and there were only 2 trades that day. Perhaps a size of 5 per leg was too small. I don't really know.

So the legging vs spreading debate has now swung more in favour of spreading, for this particular trade at least. I'll feed my monkey Macadamia nuts for now.


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## sails (24 October 2009)

cutz said:


> Hi Guys
> 
> Something occurred to me as i was executing a a spread yesterday.
> 
> ...




Cutz - if another retail trader picks off your leg - then the MM will simultaneously execute the leg he is holding which means your deal is done.  Mind you, the MM is probably laughing at his good fortune and at the stupidity of the retail trader who picked it off at such a poor price.

If the MM only puts one leg in MD, you can be pretty sure that is the leg that will get the worst possible price.  The leg the MM is holding is the money maker.  

Does that help?


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## sails (24 October 2009)

Fox said:


> I've had even a basic bull call spread knocked back, twice now. The order was just not acknowledged. If you use TWS, the status colour is light blue.
> 
> I then tried legging and all was fine. This limitation placed by MMs is another case for legging. Sometimes, you just don't have a choice.
> 
> ...




Fox - see last post to Cutz - a retail trader can transact one leg as the MM will then simultaneously transact the other/s.  

It's frustrating when TWS simply doesn't want to acknowledge an order.  I have never had complex orders with Oz brokers knocked back - I guess we get what we pay for!   I once tried to enter a butterfly on the Oz market with TWS and it said it wasn't an available strategy - even though I had traded them before on TWS and it was fine the next day.


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## cutz (24 October 2009)

sails said:


> Does that help?




Thanks Sails,

Yep that makes sense, i never would have guessed that the spreads i initiated get routed via a MM, i always though that a solitary leg sitting in a nil quoted level was placed there by my platform (i can relax now that i know it won't be picked off ).

BTW, good on ya Fox for sparking a spread discussion, it's made the way i trade a whole lot easier.


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## sails (24 October 2009)

cutz said:


> Thanks Sails,
> 
> Yep that makes sense, i never would have guessed that the spreads i initiated get routed via a MM, i always though that a solitary leg sitting in a nil quoted level was placed there by my platform (i can relax now that i know it won't be picked off ).
> 
> BTW, good on ya Fox for sparking a spread discussion, it's made the way i trade a whole lot easier.




That's my understanding anyway!  When I first started trading options, I was initially with a full service broker and trading covered calls - so most spread orders were rolling the sold call.  I was also using WebIress so I could see clearly what was happening in MD (level 2).  In most cases, both legs of the spread order would be visible in MD.  Then on one order, I could only see one leg of my order at a ridiculous price.  I phoned the broker who laughed and said - yeah the MM has put that one out and will keep the other, more profitable side for himself.  The MM is hoping a retail trader will pick the one off in MD so he can make the most money off the other side.

So, I am assuming it is still the same.  Any MMs reading these threads remain very silent - so apart from watching the action in MD, it's a bit of guesswork.


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## Fox (24 October 2009)

Thanks Sails for you MM insights. 

On a MM related topic, I experienced something fishy yesterday which I'm trying to explain. There was a BHP OTM option with no quotes. Using TWS, I submitted an Request For Quote (RFQ) and the MM responded with the obligatory 30 second quote ie. bid/ask spread.

I also had the MD displayed for that OTM option as well. When the MM responded to my RFQ, the MD showed a queue, NOT 1 but 3 quotes deep. After the 30 second period, all 3 quotes in the MD disappeared simultaneously.

Why does the MM bother putting 3 quotes in the MD instead of 1? Although unlikely, is it possible that there are 3 MMs competing for BHP option trades? And all 3 competing MMs are somehow required to responded to RFQs for 30 seconds?


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## sails (24 October 2009)

Fox said:


> Thanks Sails for you MM insights.
> 
> On a MM related topic, I experienced something fishy yesterday which I'm trying to explain. There was a BHP OTM option with no quotes. Using TWS, I submitted an Request For Quote (RFQ) and the MM responded with the obligatory 30 second quote ie. bid/ask spread.
> 
> ...




Hey Fox - you're welcome - but please remember any insights from me are mostly from careful observation and attempting to put the pieces together.

When I first started, the ASX used to put out a monthly PDF with all sorts of option related info.  It also contained the list of MMs that were quoting on each optionable stock.  It stated which ones were continuous quotes and which ones were by quote request only.  Most of the optionable stocks hardly had any MMs - many of them only had one MM which quoted only on request. This list was helpful as I decided to remain with mainly BHP and the big four due to them being the best for MM liquidity at that time.

BHP was at the top of the list with the most MMs and, if memory serves me right, I think it was around 10-12 MM firms and the majority were on continuous quotes.  I thought that meant there would be some competition between them, but methinks they must have some sort of an arrangement - maybe they take a half hour each (entirely my imagination - no fact basis!).  But it is strange that they don't seem to be concerned about competition with another MM firm.  I don't know why they operate so differently to US MMs who seem keen to snap up your order (within reason, of course).

Now, when they are on "continuous" quoting - that usually only means obligation for a certain number of strikes around the stock price and how far out in time is also a limited obligation.  That would explain why no quotes for your FOTMs.   Also, I believe "continuous" only means for a certain percentage of the day.  Same with "quote requests" - they are only obligated to respond to a certain percentage - so if others have been requesting quotes, there is no guarantee your request will get a response.

A broker once explainted that MMs quotes are handled automatically.  When we put in a quote request, we simply see what has been invisible - albeit for a 30 second window of opportunity. 

So, when you get a few levels of MD for that tiny 30 second window, I would think it's because of the different MM firms that are running automated quotes. In the past when I have requested quotes for less liquid optionable stocks, it is quite common to only get one line - sometimes there's no response at all.

One little trick with that 30sec window of opportunity is to take a screen shot - that way you can take the time to digest it properly - work out IVs, etc. without trying to write it all down and risk getting something wrong.

Re-reading what I have written above really confirms what a joke it is trying to trade more advanced strategies with ASX options!


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## Fox (24 October 2009)

Hi Sails,

Thank you again for writing such a detailed reply. I do appreciate your thoughtfulness and effort. 



sails said:


> When I first started, the ASX used to put out a monthly PDF with all sorts of option related info.  It also contained the list of MMs that were quoting on each optionable stock.



I presume this PDF is no longer put out by the ASX? I would be keen to peruse it if available. I'll hunt around the ASX website to try my luck.



sails said:


> A broker once explainted that MMs quotes are handled automatically.  When we put in a quote request, we simply see what has been invisible - albeit for a 30 second window of opportunity.
> 
> So, when you get a few levels of MD for that tiny 30 second window, I would think it's because of the different MM firms that are running automated quotes.



Aaahhhh! That explains why I saw what I saw. I still don't understand the need for keeping quotes invisible. Do the MMs hope to profit from stray orders that are totally overpriced? Why not just keep the quotes visible?



sails said:


> One little trick with that 30sec window of opportunity is to take a screen shot



Thanks for the tip. Will take the pressure off making a decision.



sails said:


> Re-reading what I have written above really confirms what a joke it is trying to trade more advanced strategies with ASX options!



Talking about jokes, I found this amusing game to play during the trading day. I once noticed a WOTM option traded at a ridiculous price. The MM's ask price was so high but some poor soul actually paid for the ask price. 

I can't quite remember the ask price but I'll just assume it was $0.900 for discussion. I decided to see what would happen if I put a sell order in for $0.895. My sell order was quickly superceded by a new quote from the MM for $0.890. I then amended my order to $0.885. No prizes for guessing. The MM's automated system put in a new quote of $0.880. This went on and on until we approached prices nearing the day's IV. The MM's quote magically stopped and my sell order ruled.

This clearly shows that the ask prices are merely used to trap innocent newcomers. I recall reading an introductory book to options trading which suggests that you pay the ask price when buying options. To think that I used to be one of those poor souls.


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## Grinder (24 October 2009)

Nice disccussion you guys got goin here.



Fox said:


> Aaahhhh! That explains why I saw what I saw. I still don't understand the need for keeping quotes invisible. Do the MMs hope to profit from stray orders that are totally overpriced? Why not just keep the quotes visible?




That would be my guess. The MMs seem to do as they please and can easily take an unsuspecting retail trader, the whole operation seems like a complete wrought. Glad I'm trading US now.


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## Fox (24 October 2009)

For the curious, these are the dreaded Oz MMs that I got off the ASX website (Appendix 3 of http://www.asx.com.au/products/pdf/asx_derivatives_and_your_company.pdf). The next piece of the puzzle is to work out which MM is assigned to a particular option series. The list of thieves include:


```
Citigroup Global Markets Pty Limited – Broker code AU905
Macquarie Options Pty Limited – Broker code AU908
Sandy Bay Trading Pty Limited - Broker code AU913
Liquid Capital Australia Pty Limited - Broker code AU916
Optiver Australia Pty Limited - Broker code AU923
Principle Strategic Options Pty Limited - Broker code AU928
Torque Trading Pty Ltd - Broker code AU929
Blue Shark Trading Pty Limited - Broker code AU931
UBS Securities Australia Limited - Broker code AU933
JP Morgan Securities Australia Limited - Broker code AU937
Timberhill Australia Pty Limited - Broker code AU940
SAEN Options Pty Limited - Broker code AU942
Susquehanna Pacific Pty Limited - Broker code AU945
JB Were Registered Traders Pty Limited - Broker code AU950
IMC Pacific Australia Pty Limited - Broker code AU951
```


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## sails (25 October 2009)

Fox - here is one from November 2005 - I haven't been able to find them on the ASX site for ages.  I would imagine things have changed somewhat in the last 4 years, but a least it gives you some idea what I've been talking about - the info starts on Pg 2.


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## Fox (25 October 2009)

sails said:


> here is one from November 2005



Thanks Sails. I could not locate this info during my hunting trip around the ASX website yesterday.

I found it interesting that on paper (pdf file), the impression given is that of competition among MM for my humble single contract order. The reality of course is vastly different.

We are swimming among sharks aren't we.

I think that tight spreads can only result from large volume of trades. Having lots of MMs will only have a marginal effect on tighter spreads. I take the case of AMC where 8 MMs were listed. From observation, AMC sometimes trade as little as 8 trades per day. Only the most desperate among the 8 MMs will even bother with AMC IMO. 

So we end up with the chicken and the egg dilemma. Tighter spreads lead to more liquidity. More liquidity leads to tighter spreads.


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## wayneL (25 October 2009)

> Blue Shark Trading Pty Limited




The "Blue" is probably a redundancy.


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## cutz (25 October 2009)

Fox said:


> So we end up with the chicken and the egg dilemma. Tighter spreads lead to more liquidity. More liquidity leads to tighter spreads.




I think the egg comes first here Fox,

The market makers also need to eat and until volumes increase a great deal we are going to have to take what we can get.

Even our biggest stocks have relatively little liquidity in the options, putting myself in the shoes of a market maker i wouldn't be falling over trying to attract a couple of contracts.

In contrast the volumes in the US are phenomenal, 1-2 point spreads are not unusual on the big stock options and the MM's can still afford to pay the bills.


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