Are You Missing the Bigger Options Trade?

Options activity isn’t always as simple as a single call or put. Market Chameleon’s Dmitry Pargamanik joins IBKR’s Jeff Praissman to explore multi-leg options strategies, how traders analyze spreads and options flow, and what larger trades may reveal about activity in the market.

Summary – IBKR Podcasts Ep. 426

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

Hey everyone, this is Jeff Praissman with Interactive Brokers. My pleasure to welcome back to the IBKR Podcast Studio, Pargamanik from Market Chameleon. How are you?

Dmitry Pargamanik

Hi, Jeff. How are you? Thanks for having us.

Jeff Praissman

Oh, I’m doing great. I love having you come in. Even before we get started, for our listeners, Will and Dmitry do a YouTube show every morning right before the market opens, so it’s always a great thing to check out if you’re into options trading. We were lucky enough for them to just come by and put on a webinar for us as well for multi-leg option strategies.And as they normally do after the webinar, they come into the studio and we take a different angle and do a podcast for our audience as well. So, Will and Dmitry, let’s get started. For traders who are comfortable buying calls and puts, what are some of the biggest advantages of moving into multi-leg option strategies?

Dmitry Pargamanik

The multi-leg option strategies allow you to structure a strategy that you can’t do simply with buying or selling a call, or buying or selling a put. So when we look at just buying or selling a call or a put, a lot of it will be directional or maybe lack of movement if you’re selling an option. When we take multi-leg options where we’re putting on two, three, or four legs, that allows you to structure a strategy with a different particular outlook that you can’t do with a single leg. So, for example, you may look at a strategy where you think that a stock will be range-bound in a certain range and it’s not gonna leave that range to the upside or downside, or it will pop out of that range on the reverse.

You could structure a strategy where you have a time decay view or even an interest rate or a dividend view, where you could hedge off a lot of the risk and narrow it down to certain things like time decay, maybe a dividend or an interest rate play, or you could also do a volatility type of strategy. So when we look at a combination of options, you really can change the different type of outlook strategies that you’re looking at that don’t necessarily have to deal with the direction of the stock.

Jeff Praissman

Yeah. So you kind of worked perfectly into my next question because there’s several predefined option spreads such as vertical spreads, iron condors, calendar spreads, diagonals, straddles, and so forth. So how do traders decide which strategy best fits their outlook on price, volatility, and timing?

Dmitry Pargamanik

First, you’ll have to have some type of an outlook. It could be a volatility outlook. It could be something where you’re looking at a range. Maybe you’re trying to capture some time decay from one period, hedging yourself in a time spread.So you’d have to take a look at that outlook and really understand which strategies apply to that outlook and the best way to apply it. So there’s no one rule because we have lots of different ways to strategize around it. You don’t even need to do it one by one. You could do a ratio spread. You could involve multiple legs, not just two legs, and you could go across different expirations and strikes. All that is very dynamic. So you’d have to really understand it, but the basic strategies really give you kind of a starting point.

Jeff Praissman

And one of the benefits of spreads, or I should say certain spreads, because obviously if you’re short a straddle, the risk isn’t really defined. But one of the benefits of a lot of spreads, let’s put it that way, is defined risk. So how does limiting risk with multi-leg trades change the way professional traders approach the market?

Dmitry Pargamanik

Yeah, so by using multi-leg trades, you actually can offset some of that risk that you don’t want. You can narrow down the risk that fits your particular outlook, and that allows you to trade with more confidence, trade in a different size or risk portfolio, and allows you to hedge things off you may have not been able to do with just a simple call or put. So this gives the professional trader or trader with larger size a lot more confidence to structure something that fits that particular outlook.

Jeff Praissman

And a lot of institutions, and even individual traders, but especially institutions, really gravitate toward SPX, NDX, VIX, those index options. Why are they so popular with, I guess I should say, larger-sized traders?

Dmitry Pargamanik

Right. So those indexes are popular for a few reasons. A lot of them are very liquid with tight spreads. It also allows you to hedge off systemic risk quickly. That’s one place where you could look at market risk, where you could just hedge off an SPX, S&P 500, or take a particular viewpoint on the market where you don’t need the individual stocks. You just have a view of the market doing one thing or another. And another thing that the indexes offer is that they’re European exercise. So you take away some of those components of early exercise or, as you know, they’re cash settled. You don’t have delivery of the underlying. All those make these types of instruments attractive to institutional traders, but a lot of retail traders also trade those index options.

Jeff Praissman

And not all spreads are created equal, right? Like a vertical spread, fairly simple to understand: same expiration, different strikes. But a couple of spreads that span across expirations, such as a calendar spread or a diagonal spread, can be a little bit confusing for newer traders on how to exactly price them and track them. But what opportunities are traders trying to capture when they use these multi-expiration strategies?

Dmitry Pargamanik

Yeah. So we do see a decent amount of trading in calendar spreads and diagonals, like you mentioned, where you’re looking at a strategy that crosses different time expirations: shorter expiration, longer expiration. A lot of those use cases happen to be rolling positions. So a position that exists and will expire soon, certain traders would want to close out of it and roll into a further month or maybe a further month with a different strike. So a further month with a different strike will give you a diagonal spread; same strike will give you a calendar spread. So that’s a roll. Sometimes you’re opening on both sides, buying one, selling another. So that’s a different type of strategy. In a calendar spread, you’d be looking at the differences in the implied volatilities and vega of the options to capture potential implied volatility divergence if you think one is overvalued versus the other in its implied volatility and vega.

Also, perhaps a time decay where you think nothing will happen between now and a certain date, and then implied volatility or volatility will start to increase. So those are things where you could see calendar spreads. On the flip side, some people use calendar spreads where they see implied volatilities are high. They think there’s gonna be a lot of movement and they want some gamma with the expectation that at a certain point things will calm down and implied volatilities will fall, so that would be a short calendar spread. So there are different use cases for them that you can do within one expiration.

Jeff Praissman

And data is something that comes up with almost all, if not all, our webinars and podcasts. We always talk about how much data’s out there, and we talk about your Market Chameleon tool that helps aggregate that data and make sense of it. And IB, obviously, on our platform, we have other types of screeners and scanners. But what challenges do traders face when they’re trying to identify meaningful multi-leg activity without the help of a screener? What are the challenges without using one?

Dmitry Pargamanik

So when we look at the market, the data itself comes out as raw data with some other fields and information. To take that information, you’d have to start processing it to figure out, well, what’s going on here? Because you’re just getting hit with data nonstop. So to make it meaningful, you’d have to start aggregating or connecting the related data and trying to figure out, well, what actually happened here? You could filter out maybe a particular big trade or a sequence of trades that look like part of one big trade.

Jeff Praissman

Mm-hmm.

Dmitry Pargamanik

With multi-leg trades, it’s particularly challenging because you get the data and you get the trade of each leg, and you get an indicator that these are part of a multi-leg trade. Then you got to put them together and stitch them to see, well, what’s the most likely trade or strategy that occurred here? So there’s an inference to the multi-leg trades that you’d have to make based on that data, because it doesn’t come out that cleanly where, well, here’s somebody who bought a call spread, somebody sold a call spread. They’ll just give you, “Here are a bunch of legs that traded,” and they’re marked multi-leg. And you’re like, “Okay, well, I see two legs here, same expiration, different strikes. That looks like a call spread. I see three legs with these types of proportions. That looks like a butterfly.” So you’d have to start making those inferences. And that’s because there’s a lack of any additional information out there. So you’re dealing with whatever the exchanges provide.

Jeff Praissman

And in the webinar, you and Will discussed how trade analysis tools can identify likely spreads, rolls, and other multi-leg positions from different individual option prints. So why is it valuable for traders to understand what the larger market participants may be doing?

Dmitry Pargamanik

Yeah. Well, first we’d have to take that data and compile it to see what we think the trade or the strategy is here. And then we take the larger trades because the larger trades tend to set price discovery. And in addition, those larger trades, sometimes when we look at them, a large trade could be part of a sequence of other large trades. It could be a pattern because larger traders tend to be more active in the options market, and it’s recurring, right? So you might see a retail trader come in, take a shot, and sometimes never come back. But large traders tend to be very active in the market. And when you look at how those large trades behave, you understand the markets, the fair values and how they’re established, and what might be happening beyond the print.

Jeff Praissman

And continuing down that road, when you’re using a screener to monitor multi-leg trades, what are some of the most important things traders should focus on? The strategy type, trade size, implied volatility, expiration? Is it all of the above? Is it something else entirely? I want you guys to let our listeners know.

Dmitry Pargamanik

Yeah, I think it’s all of the above because you start out with something that you’re particularly looking at. Let’s say today I want to look and see what type of call spreads are trading in XYZ. You filter those out, then the next question is, well, what expiration are traders targeting?What are the strikes they’re targeting? Are these in the money? Are they out of the money? Are they longer dated or shorter dated? Really, all of the above come into play because each piece of information tells you something different. And it all comes together to paint the full picture.So I would say really all of the above matter.

Jeff Praissman

That’s exactly what I thought. Well, Dmitry, this has been great as always. Any final thoughts you’d like to leave our listeners with?

Dmitry Pargamanik

I think that for traders, particularly those traders looking at calls or puts, buying or selling, the very next stage, and really where you can benefit on a much wider scale, is how to structure multi-leg trades. That is just a natural progression for people that go beyond just the single buy or sell. Eventually, if you’re in options, you’re gonna start doing multi-leg option strategies. So I think starting out maybe with a screener and just observing the markets and seeing how these things trade in a market, how they progress, it’s just a valuable lesson and it’s a toolkit you want to keep in your back pocket.

Jeff Praissman

Yeah. And as we discussed, obviously not all, but certain spreads with defined risk are actually less risky than individual legs.

Dmitry Pargamanik

Yes, exactly.

Jeff Praissman

Depending on what side you’re on, but—

Dmitry Pargamanik

You’re reducing the risk. You could be reducing the risk by a lot by using multi-leg.

Jeff Praissman

Guys, this has been great. Thanks for coming by. And again, for our listeners, you can find more from Market Chameleon on our website, interactivebrokers.com. Go to Education, find past webinars and podcasts, or check out their YouTube channel at 9:00 AM Eastern Time, right guys? Right before the market opens Monday through Friday. And until then, talk to you guys next time.

Dmitry Pargamanik

Thanks, Jeff.