More than One – Multi-Leg Option Combinations

Will McBride and Dmitry Pargamanik cofounders of Market Chameleon join IBKR’s Jeff Praissman to discuss multi-leg option combinations and how to screen and  potentially interpret the trades.

Related Links:

Podcast :  https://ibkrcampus.com/podcasts/ibkr-podcasts/more-than-one-multi-leg-option-combinations/

Webinar: https://ibkrcampus.com/webinars/options-multi-leg-trade-screener/

Summary – IBKR Podcasts Ep. 128

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman 

Hi everyone. Welcome to IBKR podcasts. I’m your host, Jeff Praissman. It’s my pleasure to welcome back the co-founders of Market Chameleon, Will McBride and Dmitry Pargamanik. Hey guys, happy 2024. 

Will & Dmitry 

Hey, Jeff. Thank you for having us. 

Thanks for having us as always, Jeff.  

Jeff Praissman 

Oh, my pleasure. And thanks for coming by the IBKR podcast studio. We just finished up the great webinar on multi leg option strategies and how to scan for them. I’d like to take this opportunity on this podcast to take a little bit of a deep dive into that subject. 

So for our listeners, if you missed the webinar, there’ll be links in the viewing notes for this podcast. So to kick it off, multi leg option trades, they obviously contain more than one option. But there are certain combinations which have specific names such as like strangle, vertical spread or Iron Condor just to name a few. Will and Dimitri, are all spreads created equal and perform the same under the same market conditions? Or are different combinations meant to profit or protect against certain movements or non-movements in the underlying? 

Dmitry Pargamanik 

When we look at multi leg trades, what we’re talking about is when people take options instead of just a a single leg call or put, they’ll combine options. More than one option in a single trade to express a certain viewpoint, which can be much more focused. So instead of just using options for example as a directional play, you can be more creative and use options for pressing your view on volatility. You could construct option strategy based on a trading range or sideways trading. You could also use them if you have an opinion about interest rates or dividends in a particular stock, or even if the stock may become hard to borrow. So when we look at multi-leg trades, they become very important because you can glean much deeper understanding how people may be using them and what may be the intent of the strategy. 

Jeff Praissman 

So it’s more than just looking at overall volume, in other words. And looking at spread volume versus just overall volume, you are going to possibly see volatility movements, maybe price discovery and certain other things that just straight volume by itself can’t give you the full picture for. 

Dmitry Pargamanik 

Yeah, exactly. One of the starting points for many traders when they do their research is to look for unusual option volume. And when you look at an unusual option volume, you could take a particular stock and say, okay, typically on an average day there are 3,000 options contracts that trade in this stock and today we see 10,000 contracts. But now that you filtered that out, the real question is what lies underneath that volume? What are people actually doing? And many times, the bulk of the volume, or maybe even most of the volume could be coming from multi-leg options spreads.  

And that’s why they become very important because with that, when we look at the options we have to work backwards and say, well, what were the different legs of the trade? And try to interpret what was the targeted strategy behind this trade? And that’s when you start diving much deeper into that volume to understand what is trading.  

Because it doesn’t matter if you’re in the business of buying and selling sneakers or cars or real estate, you have to know the market that you are participating in and what is trading. What are the prices people are transacting at, what are the trends, what is typical, not typical and part of that is to analyze the actual volume and what is that trading activity. 

Jeff Praissman 

So what percentage of the overall option volume are multi-leg trades? 

Dmitry Pargamanik 

I think a lot of people will be surprised at how much of our market is comprised of multi-leg trading. Now usually we’re seeing somewhere in the 40, mid 40% of the overall volume is multi-leg trades. And if we add contingent trades which are trades that also include a stock leg to it, we’re getting close to half the overall trading volume is in these types of strategies. And it’s been growing and becoming more and more popular. So it’s a very important piece of the trading activity overall. 

Jeff Praissman 

And what are some of the more popular spreads that you found are trading these days? 

Dmitry Pargamanik 

So far, the most popular strategies are the ones that involve two different options. Two legs. Look, a bullish call spread or a put spread and that’s followed by calendar spreads, diagonal spreads. Straddles, strangles, we start seeing some of those types of trading drop off a little bit.  

Usually the vertical spreads and horizontal spreads are most popular by the number of times we see those types of trades. We do see three-legged trades such as a butterfly. We even see four-legged trades like iron condors and even more. But the use of those even though it is growing and we’re seeing more and more and more use cases, they drop off significantly compared to like 2 legged strategies.  

Jeff Praissman 

Yeah and that makes the most sense to me as well. That the two-legged strategy would be the most popular and as you’re adding more and more legs to it, it’s probably less and less used or less and less popular among traders.  

But who is using multi-leg trades? Is it professional traders? Is it retail? What sizes are you seeing that would lend you to think that they’re spread evenly? 

Dmitry Pargamanik 

Yeah, that’s one of the things that we track when we take a look at these multi-leg trades. And we bucket them based on the trade quantity. Because we do see very large volume in certain multi-leg trades, but then we see a lot of trades that are employing multi-leg strategies, but you’ll see maybe one, two, three-lot type spreads which are more typical of retail size trades. And we see about 70% of the trades coming from retail size orders.  

That doesn’t mean 70% of the overall volume, but 70% of the trades themselves to us look like they’re more retail sized trades. But we do see very big, large traders using multi-leg trades as well. So we do see them across the board, but they are becoming very popular with retail. 

Jeff Praissman 

Now I want to kind of take it from the other side of it, where we start talking about from the trading side. But how do the exchanges handle multi-leg trades that are submitted as combinations? Do the exchanges mark them (the trades) as spreads? Or is it just something that you sort of interpret through the volume and the time in sales? And kind of extrapolate the fact that it wasn’t spread based on other factors. 

Dmitry Pargamanik 

Yeah, like how do we know that that a spread actually traded and it wasn’t just wo different calls that traded separately? That’s a good question. And right now the way the trades are being reported on the trade tape is that they look like individual trades, but they are marked that it is a multi-link.  

So you had a call spread. What you will see is two different trades. Two different calls that traded for this quantity price and so forth. But the market as this was a multi-leg trade and they kind of leave it at that. So it would be up to you to look at that data information and come up with reasonable logic to stitch back that data together to say, well, these two individual trades are related and then make an interpretation that the most likely strategy based on this information was it was a call spread for example, or a put spread.  

So there’s information out there on the trading tape. But it’s limited, but it gives you enough information that most of the time you could come up with a logical conclusion what just transpired. And that’s the way right now it’s being reported. So they won’t come out and tell you that this original order was a bullish call spread, for example, or a straddle or strangle. It doesn’t go that far. So it’s left up to interpretation. Once you gather up that data and make that link. 

Jeff Praissman 

Besides for volume, which is obviously important in drawing to decipher what sort of spreads and how much they traded. When looking at spreads and trying to determine the reason behind putting on the position, what are other important factors such as like open interest or underlying price, news- what else plays into your analysis? 

Dmitry Pargamanik 

Yeah. No, that’s a good question too, because sometimes you could look at a particular spread and you could kind of figure out what the intent was based on other circumstances around it. Look for example, we see very large dividend capture strategies right before the stock goes ex dividend. You see very large spreads going up and deep in the money calls with open interest. Because certain players out there are trying to take advantage of perhaps the open interest somebody forgets to early exercise.  

Or deep in the money puts, for example, that has existing open interest and there will be other traders that will try to exploit somebody else’s inefficiency not exercising those puts for the interest. And you could kind of figure those out based on other circumstances. This situation that I gave you is open interest and maybe in the case of the next dividend, if the stock was going next dividend the next day. 

And a lot of that is from experience. You’d have to know like these are the types of traders out there and this is what their intent is in this situation. Sometimes we see roles that are that are recurring. They’ll roll from one option to the next, and sometimes you could even see it’s consistent by the timing as well. And there are certain strategies out there that have to roll that are just based on rolling to the next exploration, for example. So these are other clues that you could tap into by using other information. Like you said it could be open interest, it could be an ex-dividend coming up, it could be expiration, it could be earnings. And that will allow you to make better determinations of what just happened. 

Jeff Praissman 

Now, is it possible to determine which side of the spread the trader took? 

Dmitry Pargamanik 

Yeah. So every trade will have a buyer and a seller to transact. And the question is, well, maybe who’s the initiating trader? Or the person the end user wanted to initiate the trade with and maybe access the liquidity of the markets.  

And sometimes yes, sometimes no. Sometimes you can make a determination who’s the initiating trader or the most likely initiating trader based on certain surrounding circumstances. Like the markets at the time of the trade and where the trade price happened relative to the markets, but it’s not always that simple.  

You could look at how the markets were lined up prior to the trade, at the time of the trade and after the trade. That could clue you in. Sometimes you’d have to look at if it was maybe a call spread that traded. You might want to take a look at the synthetic or the corresponding put spread where the market is to get a sense of where the initiating trade came from.  

So that one- it’s not a simple answer. It’s not provided to you on the trade table where there was an incoming order from a customer and they bought it from a market maker. We don’t have that information. That’s not provided. But there are surrounding data points that there are instances where you could make a logical inference with a high degree of confidence. 

Jeff Praissman 

Got it, got it. Now do people day trade spreads or are they more of a long-term play? 

Dmitry Pargamanik 

Yes. So we did look at that as well. When we looked at the spread and sometimes you will see certain spreads that they will trade in the morning. And then we track the trading in that particular spread to see if they trade out of it, they hold on to it, do they accumulate more? And we see both sometimes. People will look at a pull spread, for example, and they day trade the call spread. They’ll have a viewpoint that day, maybe that the stock is more likely to go up, for example, and they’re going to choose to use a call spread to get that long exposure. And we’ve seen the call spreads sometimes trade in the morning and they’ll trade at them in the afternoon, sometimes at the end of the day. And sometimes they’re locking in profits, sometimes they’re locking in losses as well. And there are other times where people will put on a spread and they will hold on to that spread all the way till that expiration. You know, even if it’s going out in many months. So it’s very interesting lots of different ways people will use the multi-leg trades and trade them and we’ve seen both sides. 

Jeff Praissman 

In several past podcasts and webinars, the three of us have discussed option volume. It’s been a subject that we go back to and discuss. And I’m curious. Generally it’s always been overall option volume that we’ve talked about. But I’m curious what underlyings have you seen have the most spread volume recently? 

Dmitry Pargamanik 

What we’ve seen is that pretty much across the board, we’re seeing people use multi-leg trades, almost all stocks. So it’s not even very.. it’s not exclusive to certain particular stocks that people use multi-leg trades. Like for example 0DTE options. You only see them in a few places where the list 0DTE.  

Multi-leg trades- we’re seeing them applied across the board from the top tier spots. The Amazon, Mega, Tesla, all those. But even in the stocks that have even less volume, we still see a good amount of multi-leg strategies employed there.  

Which is good because I think that people are taking these types of strategies which allow you to mitigate your risk, maybe concentrate or increase your returns by focusing on certain exposures that you want to target. And that’s been the trend that we’re seeing in multi-leg trade really been applied across the board.  

Jeff Praissman 

Well, Will and Dmitry, thank you guys so much for coming by. It’s always a pleasure to have you in the studio. And for more from Market Chamelon, please go to ibkr.com, click on education, then IBKR campus and select IBKR Campus Contributors and look for Market Chameleon. And for our listeners who want to dive deeper into multi-leg combinations, I highly recommend watching the webinar that Will and Dmitry just finished. The links are in the study notes. Thank you for listening and until next time, I’m Jeff Praissman with Interactive Brokers.  

Will McBride 

Thanks Jeff. 

Dmitry Pargamanik 

Yeah. Thanks guys!