Adjusting 101: How to Add Legs to an Existing Options Position
When referring to options trading, it’s easy to first think of stock trading. Especially given that most, if not all traders, begin by using stocks before some graduate to using options. When a trader buys stock — say 100 shares — what options do they have as the trade develops? In its simplest form, the trader can buy more stock or sell some or all of their holdings. In options trading though, there are a vast amount of options, one of which involves adding an options leg.
Again, let’s keep it as simple as possible for the moment. Say we are bullish shares of ABC, so we buy a lone call option on the name. For our example, ABC is trading at $45 and we purchase a $47 call for $1.00 expiring in 45 days.
Let’s say that the stock rallies to $48.50 15 days later, giving our $47 call a value of $2.10. At this point, we have a couple of options. First, we could sell the call outright for $2.10, pocketing $1.10 in profit (not including trading commissions). This is good for a return of 110% — great work!
If we don’t want to sell, we could also double-down on the position by purchasing another $47 call option — effectively raising our cost basis to $1.55 — and hoping for more upside. After all, if the momentum continues, we now have double the position with a still-profitable cost basis.
But this is where we diverge from the stock trading strategy — where buying or selling the position are our only options. With options, we can add another options leg, completely altering the strategy at hand.
Why would we do this? While each circumstance has its own unique set of outcomes, we can add and subtract certain options legs to improve our risk-reward scenario. In the case of ABC, our $47 call option now expires in 30 days, while the stock price is trading at $48.50. Let’s say then that the $50 call option is trading for $1.00. If that’s the case, the trader can consider selling the $50 call option short, against their long $47 call option. In effect, the trader is simply creating a bull call spread.
However, unlike standard bull call spreads that are put on for a net debit — thus risking the premium the trader pays in the event the spread closes out-the-money — this spread is different. In effect, it’s done without risking any capital. By purchasing the $47 call for $1.00 and selling the $50 call option after the underlying stock has appreciated, the trader has an effective net debit of $0.00.
Importantly, it should be noted that the trade isn’t risk-free. While the trader has recouped all of the capital they paid to put the trade on, they are still risking the current value of the spread. At present, the $47 call is worth $2.10. Its intrinsic value stands at $1.50 ($48.50 stock price – $47 call price = $1.50).
In other words, just because the trader is no longer risking their own capital, doesn’t mean they’re not risking the current value of the spread. If ABC suffers a sudden reversal lower, the trader will see a loss in the sense that the value of the spread will decrease.
Does this mean they should avoid adding a leg in the scenario? Not necessarily.
Consider that by selling the $50 call and effectively creating a bull call spread, the trader now has the potential to reap a full value of $3.00. That would require ABC stock to close over $50 on expiration. But should it do so, the trader will see gains of almost 50% on the spread’s current value of $2.10, all without risking their own capital.
It looks like this:
Account balance before the trade: $10,000
Initial purchase of $47 call for $1.00; total net debit: $1.00.
Account balance after the trade: $9,900
(ABC rallies from $45 to $48.50).
Sell the $50 call for $1.00; total net debit of spread: $0.00.
Account balance after the trade: $10,000
Position currently held: One $47-$50 bull call spread
Pitfalls to Adding an Options Leg
It’s not always a good idea to turn a long option into a spread. In the scenario above, we were able to reduce enough risk, while still having upside to $50. However, say in a different instance we could only get $0.50 for the $49 call.
In this case, we’re still carrying a $0.50 risk (albeit, better than the initial $1.00 risk), but the reward has not improved. Our maximum reward from the $47-$49 bull call spread is just $2.00. Heck, we can sell the call right now, completely reduce our risk by taking our money off the table and realize a better reward.
It’s one thing to adjust the strategy by adding an options leg (or subtracting one) to improve our risk-reward; to improve our position based on what the market is presenting us. However, it’s a completely different scenario to plan on legging into a spread.
What do we mean by that? It’s one thing to buy the $55 call option and add a short options leg to it down the road when conditions are favorable. It’s another thing to plan on buying the $55-$57.50 bull call spread and buying each leg in different transactions. This is called “legging” into a trade.
In other words, some may buy the $55 call, try to time a small rise in the stock price and then sell the $57.50 call. That would lower the spread’s overall cost. But the minute amount the cost would decline by isn’t usually worth the risk the trader runs if the stock pulls back instead of rallies. Often times we’re either stuck with a riskier naked leg or a more expensive spread. Neither is worth the measly reward.