RD1 Pontification on Legging Butterflies from November 24, 2004

17:37:39 {Participant 1} Charles, thanks for the lecture on strapping on the wings for self-survival

and posterity sake. It makes a lot of sense to me. I have done my share of naked OEX straddles and am always nervous overnight especially when the terror alert goes to ORANGE. Question: Is it generally better to leg into a butterfly/condor or is it better to just put it all on at once? 17:37:44 {Participant 2} y 17:37:50 { Participant 3} you bet {RiskDoctor} Participant 1: Good question and I am glad that Participant 2 and Participant 3 are comfortable with legging into wingspreads (butterflies and condors). The simple answer of Y and you bet cannot be intended for everyone or even for seasoned pros. The answer is sometimes definitely yes and other times definitely no. It depends on the circumstances. There are two reasons to leg. The first is that all the prices are there, right now for the trading and the second is when you have an inter-day, short-term, opinion that you would like to manifest with only part of the overall wingspread to be played at first (I know lots of stories where people never got all their legs). Starting with the first reason: The trades are there waiting for you: Scenario 1 (not too practical because you can really butcher the trade): 1st leg (hardest option to get filled - do to lack of liquidity): Click, Boom, Filled. nd 2 leg (somewhat neutralizing the first leg): Click, Boom, Filled. 3rd leg (even more offsetting the exposure to the first two legs): Click, Boom, Filled. th 4 leg: Click, Boom, Filled. Wow! that was easy: like shootin fish in a barrel. Scenario 2 (more practical but still butcherable) Maybe the verticals are right there, ripe for the pickin: leg vertical to vertical: Do you remember that stuff about a wingspread, whether; all calls or all puts or an iron (calls and puts), is made up of two verticals (Chapter 6)? You know, a bull spread at one set of strikes and a bear spread at different set of strikes. So if the prices are there: 1st Vertical (how about the bull spread first if you are slightly bullish): Click, Boom, Filled. 2nd Click, Boom, Filled. Wow! I saved two ticket charges. Whos hungry? I just saved 20 bucks. Im buyin. But what determines whether it is better to leg or not? Numero Uno: Determine the average (middle) price of the overall spread that you are trying to trade. This means also checking the synthetic equivalent wingspreads. If it is attractive to you then a little more or less should be ok for you to try to place a reasonable order (meaning: bidding a little more than the average when buying or asking a little less than the average when selling). If you get filled, go mow the lawn. That would be acceptable even for a seasoned pro who does not wish to mess around taking all sorts of transactional exposure between legs (especially if he or she has no shortterm opinion and has no intention of having anything but the total package. Numero Dos: If you dont get filled there are three choices: (1) Leave the order in and go mow the lawn. If there is a significant delta to the spread, the market may have to move to your price. (2) Check the leggable values of all the wing spreads at those strikes and assess whether it is worth transacting by legging. Perhaps adding (when buying) another tick (nickel or .05 in stocks) will motivate the counterparty (market maker or a customer going the other way) an get you what you want if you have to have it. Therefore, Cancel the first order (wait for an OUT meaning the order is no longer Working in the market and depending on your broker this can take anywhere from 3 seconds to an hour and in the latter case, change brokers) and then replace it with the order with the more attractive price for the counterparty. (3) Find a different trade. Getting back to the second reason to leg: This is only for people who have the experience to be able to say to themselves, I dont care if I dont get the whole intended spread on. It becomes just a different way for him or her to be represented in the market. The reason why experience is

2004 Charles M Cottle

www.RiskDoctor.com

RD1 Pontification on Legging Butterflies from November 24, 2004

necessary for this logic is that a person who just wants a butterfly or a condor because that is what suits him or her has chosen that strategy owing to a little market analysis and that research has dictated that particular strategy. Only if the temporary incomplete wingspread (just a naked long or a vertical) is warranted or justified by that same analysis (there is more than one way to skin a potato (or do you say potato)) then and only then can this person even think to leg. But remember this example because trading is also about money management, conservation of capital, avoiding rosk of ruin, yada, yada, yada; A guy is considering an OTM 5 point call butterfly for around $1.00 where the bull spread is 2.50 and the bear spread is 1.50 and where the lowest strike call is $5.00, the middle strike call is 2.50 and the highest call is 1.00. Butterfly Price Vertical Prices Call Prices 1.00 2.50 5.00 +10 Low Strike 1.50 2.50 -20 Middle Strike 1.00 +10 High Strike

Does it make sense for this guy to leg the short calls or the bear spread first if he is bullis? No. Does it make sense for him to buy 10*$5.00 calls ($5000) when he wishes to only risk $1000 (10 one dollar butterflies)? No, but he can buy 2 of them so as to be at least represented in the market with his opinion. That t would make for a lot of legging and transaction costs. How about 10 of the high strike calls? They are only 1.00 and that would be placing his $1000 bet. Not really because that is pure long premium wasting away and now he has to be really right. His hard work and analysis said Butterfly a totally different beast. Does it make sense to buy 10 call verticals for $2.50 ($2500). Not unless he is definitely going to work the credit on the other side soon(and get filled even if slightly worse than anticipated) because otherwise he has to drop it down to 4 spreads to keep it within the $1000 willing to be lost. Well, as you can see there is a lot to consider with the prospect of legging or not.

2004 Charles M Cottle

www.RiskDoctor.com