Legging Out: Is It Worth the Risk for Traders?
Legging Out: Is It Worth the Risk for Traders?
By:Kai Zeng
Legging out unnecessarily extends the holding period and doesn’t guarantee better daily returns
As the stock market becomes more volatile, some of our balanced investments might see their profits swinging wildly, making our returns unpredictable.
This situation often makes investors question whether they should sell one part of their balanced investment to secure gains and then focus on opportunities with the other side that isn’t performing well. This method is known as “legging out of a position.”
Doing so might:
- Enable investors to increase potential profits.
- Safeguard profits from the part of the investment that’s nearly worthless and no longer provides protection to the other side.
- Decrease the number of unprofitable trades that occur because of swings in stock prices.
However, we usually avoid "legging out" of standalone investments like strangles. Removing one side first leaves the remaining part open to unlimited risk, which can make returns even more volatile and decrease profitability.
But what about strategies with limited risk—like iron condors? These involve put and call spreads that independently limit risk, raising the question of whether it would be beneficial to exit one side first if it’s already showing a significant profit.
To explore this, we conducted two studies of 45-day SPDR S&P 500 ETF Trust (SPY) strangles, adjusting by $10 increments.
Study 1:
- Closing the position at 21 days to expiration (DTE) or after achieving a 50% profit.
- Removing individual spreads if they reach 90% of their maximum potential profit.
The results showed that legging out of Iron Condors didn't have the desired outcome. Average daily returns noticeably decreased, suggesting investments were held for longer when trying to leg out.
In fact, less than 2% of scenarios showed the 21DTE/50% profit approach losing out to the legging-out strategy.
Next, we sought to shorten holding times by targeting smaller gains to improve potential performance.
Study 2:
- Same as before for closing positions.
- Removing individual spreads if the long option on the opposing side is breached.
Even in this scenario, legging out failed to perform better than our tried-and-true management approach. In fact, it showed worse results.
Takeaways:
- While it can be enticing to leg out of risk-defined positions, managing the entire trade at once proved more profitable.
- Legging out unnecessarily extends the holding period and doesn’t guarantee better daily returns.
Kai Zeng, director of the research team and head of Chinese content at tastylive, has 20 years of experience in markets and derivatives trading. He cohosts several live shows, including From Theory to Practice and Building Blocks. @kai_zeng1
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