What Is a Leg?

What Is a Leg?

Let me explain what a leg is in trading. It's one piece of a multi-part trade, typically in derivatives strategies where you combine multiple options or futures contracts, or sometimes both, to hedge your position, take advantage of arbitrage, or profit from spreads widening or tightening. In these setups, each contract or position in the underlying security counts as a leg.

When you enter a multi-leg position, we call it 'legging-in' to the trade. Exiting it is 'legging-out.' Keep in mind that in swap contracts, the cash flows exchanged can also be referred to as legs.

Key Takeaways

A leg is simply one part of a multi-step or multi-part trade, like in a spread strategy. You'll leg into a strategy to hedge a position, benefit from arbitrage, or profit from a spread. Traders use multi-leg orders for complex trades where they're less confident about the trend direction.

Understanding a Leg

Think of a leg as one part or side of a multi-step trade. These trades are like a long journey with multiple legs. You use them instead of single trades, especially for more complex strategies. A leg can involve buying and selling a security at the same time.

Timing is crucial for legs to work properly. You need to exercise the legs simultaneously to avoid risks from price fluctuations in the related security. That means making a purchase and sale around the same time to dodge any price risk.

Legging Options

Options are derivative contracts that give you the right, but not the obligation, to buy or sell the underlying security at a strike price on or before an expiration date. Buying initiates a call option, while selling is a put option.

The simplest strategies are single-legged with one contract, coming in basic forms like long call, short call, long put, short put, and even cash-secured puts where you sell a put and keep cash ready to buy if exercised.

By combining these with each other or with positions in the underlying securities, you can build complex bets on price movements, leverage gains, limit losses, or even arbitrage market inefficiencies.

Two-Leg Strategy: Long Straddle

Take the long straddle as an example—it's a two-leg options strategy with a long call and a long put. This works if you know a security's price will move but aren't sure which direction.

You break even if the price rises or falls by your net debit (cost of contracts plus fees), profit if it moves further, or lose up to that net debit. The setup yields profit whether the price goes up or down.

Three-Leg Strategy: Collar

The collar is a three-leg protective strategy for a long stock position: you hold the underlying security long, add a long put, and a short call.

This bets on the price going up but hedges with the put to limit losses. Adding the short call caps your profit but offsets the put's cost, potentially lowering your net debit. It's for slightly bullish traders not expecting big price jumps.

Four-Leg Strategy: Iron Condor

The iron condor is a four-leg strategy with limited risk, aimed at small profits when the underlying price doesn't move much. Ideally, it expires between the short put and short call strikes.

Profits are capped at the net credit received, and losses are also limited. You build it by buying a put, selling a put, buying a call, and selling a call at specific strikes, with close or identical expirations, hoping all expire out of the money.

Futures Legs

Futures contracts can combine too, each as a leg in a larger strategy. Calendar spreads involve selling a futures contract with one delivery date and buying another for the same commodity with a different date—bullish if you buy near-term and short deferred, or vice versa.

Other strategies profit from commodity price spreads, like the crack spread between oil and its byproducts, or the spark spread between natural gas and electricity from gas-fired plants.