Many multi-leg options strategies include their own hedge, reducing risks for one leg by counterbalancing them with another leg. It seems clever enough to make a trader wonder: is it possible to zero out risk entirely with the right multi-leg strategy?
I got this intriguing question from TradeKing client Jason, who’s just started trading options and is doing pretty well so far. He writes: “Is it more profitable to do multi-legged trades? And is it possible to get to no risk at all if someone is trading 3-legged options, because every directional side is covered in the trade?”
Glad to hear things are going well in your options trading so far, Jason. While it’s possible to reduce directional risk in your option trade down to zero, the return on the strategy would be very low. For example, there’s an options strategy called a conversion that basically mimicks a zero coupon bond. You buy it at a discount and at the end of the term it goes out at full value, earning you the risk-free interest rate. Not very exciting, but if done correctly would limit directional risk.
Now we can also greatly reduce the risk by increasing the legs, but then it becomes a question about how you handle the leverage. Let’s consider a concrete example. If you buy a butterfly instead of buying a call outright, the cost of the trade is only 30 cents for the butterfly versus 1.50 for an outright call purchase. But many will just buy 5 butterflies and have the same amount of risk on the table, because they can at the reduced cost. They do more simply because they have sufficient funds in the account to do more.
This is the leverage factor that many beginning option traders don’t really get. Yes, the cost of the trade is less, but if you buy more you ultimately have the same amount of risk on the table.
Now the risks between these two strategies will often change: a long call does not benefit from time decay and a butterfly usually does, so aspects of the trade change. But ultimately if you buy more because it is a cheaper trade, the same amount of risk is there if your forecast of the underlying is incorrect.
You’ve given me a chance to repeat my favorite catchphrases in this blog: the options world is full of tradeoffs. There will be risks with every type of option strategy, but the challenge is knowing the tradeoffs involved with each of them and not overdoing the leverage factor.
If you’re new to options, download our free Intelligence Report, Top Ten Mistakes New Options Traders Make (PDF). It’s full of pointers like this that will help a newbie options trader accelerate your understanding and bypass the most common mistakes.
Thanks for the question, Jason – here’s to your continued success!
Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com
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