For those of you who are familiar with a spread trade, the first rule you need to understand is how to successfully execute one, without ending up with a position that you do not want. Sometimes traders try to be a little too creative and in so doing, end up with egg on their face. The spread trade gives us the perfect opportunity to examine how this happens.
Often when a beginning spread trader decides he understands the concept of spread trading he has to be careful of a little trap called trying to leg on the trade. The eager trader will look at a hypothetical position like this below. The trader wants to put on a debit spread (a credit will work the same way) so he looks at the following scenario.
Trader A wants to do the following: XYZ is trading at $27 a share
Buy 5 XYZ Nov 30 calls @ $1.50 and
This trade is pretty straight forward you put in both tickets with a net debit of $1.00, give or take $0.05 depending on where the bid/ask is on both positions.
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However, our trader A decides he wants to buy the long XYZ Nov 30 call first, then what is known in the industry (try to leg on the trade). So Trader A puts on the first leg and pays $1.50 and gets his confirmation back. Everything is great! Until he then realizes that the underlying stock that was trading at $27 is now trading for $26 and ticking lower, he now attempts to sell the 5 XYZ Nov 35 contracts to complete his spread but the bid is no longer $0.50 its Ask $0.45 X Bid $0.40. Trader A now has not only not completed his spread trade, but now may have to pay more to complete it, then had Trader A just put in the spread order originally as he planned. Trader A now faces a dilemma and many new traders will follow suit, they try and wait for the Nov 35 calls, that are now selling at $0.45 X $0.40 to go back up to $0.50, but remembering a gentleman by the name of Murphy, the XYZ Nov 35 calls don't go back to $0.50. Or no! they drop to $0.35 X $0.40 as the XYZ stock now is trading at $25.75. Now trader A has a real problem. First his long call is down and the premium he was going to get to minimize his long side exposure is now 30% less then if he had acted immediately with the spread ticket. Trader A does have a problem. He could just take the $0.30, if he can get it! and have a $1.20 Net debit instead of a $1.00 which is $100 more if you consider the 5 contracts that he is trading, or wait and hope the stock comes back and try to get the $0.50 premium that he was looking to get initially. Of course this is hypothetical, but unfortunately, this occurs a lot more often then one would like to think. Traders, in general, love to try and gain any type of an advantage that they can, unfortunately when that happens they lose sight of their original intent of the trade, which in this situation was to reduce his out of pocket, cost with the spread. Of course there is a chance that the long call could have went up and then Trader A could have gotten more then $0.50 for the sale of his XYZ Nov 35 calls. But then again, that would be a matter of luck and if one were to try and leg on every spread that they wanted to execute, we would have a lot of terrible risk/reward ratios instead of potentially good spreads.