Exploring multi-leg options strategies: A complete guide

In their simplest form, a multi-legged strategy enables you to invest according to how you think a stock will move while hedging against the possibility it may behaves otherwise, all for less than it might cost to buy the underlying shares themselves. For example, in the first leg, you might buy a call option to purchase a stock for $50 a share before the expiration date. If the security rises above $50, the option is said to be "in the money" and can either be sold or exercised to buy the underlying shares. In the second leg, you could write or sell a call option at, say, $55 a share. The premium you receive from that trade would offset the cost of the first option, and since the strike price is higher on the second leg, you would profit if one or both options are exercised. If the stock unexpectedly goes down, both options expire worthless, but the trader would have at least reduced the cost of the option play. 

Basic components

A multi-legged option trade involves three kinds of financial instruments: call options, put options and the underlying asset. Call options give the holder the right to buy the underlying asset at a set price within a certain time frame. Put options give the holder the right to sell the asset, again at a specified price and before an expiry date. The assets in question are usually publicly traded company shares or units of an exchange-traded fund (ETF). Options contracts typically apply to batches of 100 shares.

Here are the actions that could be involved when making a multi-legged options trade with three legs, also known as a three-legged options strategy or just a “spread”:

The first leg: Buying a call option

The first step involves paying a premium for the option to acquire the stock at a set price before the expiry date. If you decide not to exercise the option, it will expire worthless.

The second leg: Writing a call option

In this stage, you might write or sell a call option to sell a stock at a certain price within a set period. The premium obtained for this option would offsets the cost of the one paid for the first leg.

The third leg: Establishing a position in the underlying asset

If you elect to sell the call option without exercising it, you may have to buy the required volume of stock at the market price to cover their short call position. To avoid this risk, many investors close both legs of the trade at the same time.

The strategies behind multi-legged option trades vary. Common examples go by the following names. 

Different types of three-legged strategies 

Straddle

In a straddle strategy, you would buy both a call and a put option on the same stock with the same strike price and expiration date. This allows you to profit if the price moves significantly in either direction. The strategy is profitable if the stock price moves beyond the total premiums paid: either above the call strike price plus the premiums, or below the put strike price minus the premiums. The strategy could make sense in scenarios where high volatility is expected but the direction of the price movement is uncertain.

Strangle

A strangle trade resembles a straddle in that you would take both sides of a stock’s potential movement, however one side is usually favoured. That is, you would take a stronger position in an expected outcome and a weaker counter-trade to limit the downside in case the trade turns out to be wrong. Some trading platforms will suggest strangle trade options to investors looking to profit from a particular outcome. 

Butterfly 

A butterfly strategy involves using four options contracts at three different strike prices to profit from minimal stock price movement. The most common configuration is the long call butterfly spread, where you buy one call option at a lower strike price (eg. $20), sell two more call options at a middle strike price (eg. $25), and buy a call option at a higher strike price (eg. $30), all with the same expiration date. The setup would generate a profit if the stock price remains near the middle strike price at expiration, balancing limited risk with a capped potential reward. Other variants designed for other outcomes include the short call, long put, short put, iron butterfly and reverse iron butterfly. 

Ratio spread

A ratio spread strategy involves buying a certain number of options and selling a higher number of options at a different strike price, typically in a two-to-one ratio. For example, you could buy one call option at a lower strike price and sell two call options at a higher strike price. The writer options would be further out of the money and therefore cheaper than the purchased one, allowing you to potentially finish with a credit even if all the options expire worthless. You would profit if the stock price moves within a certain range, but you could face potentially unlimited losses if the stock price moves significantly beyond the higher strike price, since the long position does not fully cover the short position. 

Multi-legged options strategies can benefit investors in different ways.

Risk management

Whereas simple options strategies offer binary outcomes, multi-legged trades could let you limit your downside or come out ahead in more than one scenario.

Income generation

By incorporating options writing, multi-legged strategies give you a way to derive income from options sales, offsetting or exceeding the cost of options purchases.

Hedging against market volatility

Multi-legged strategies can generate gains regardless of the performance of the underlying stock or the markets in general. Used in concert with conventional long equity positions, a multi-legged strategy could reduce overall portfolio risk.

Like any securities transaction, multi-leg option trades come with risks. The more complex the strategy, the more risks you’re likely to face.

Market volatility

Selling options comes with the obligation to buy or sell shares at the strike price once certain conditions are met. Unpredictable price movements create the potential for you to be required to buy or sell shares at an unfavourable price.

Liquidity concerns

If you sell an option contract that is in the money – essentially closing the long leg of the strategy – you may be left with an uncovered short leg. That is, you must acquire the stock at a possibly unfavourable market price to fulfill the put contract that you wrote or sold. 

Loss potential and downside risks

If you are wrong about the direction of stock movements and options expire, you will bear the cost of the premiums and fees paid.

To avoid the possibility of uncovered legs of a transaction, it can be common for traders to close both sides of the trade at the same time. As for volatility, only knowledge and experience can mitigate market risk.