Home Forums Main Forum The Art of Legging

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  • Curve Advisor
    Keymaster
    Post count: 612
    #1418 |

    While the CME offers many structures that you can trade directly as a package, there will be times when you want to leg two (or more) different pieces of a trade. Legging systems (like TT) have gotten very sophisticated over the years. So the newest generation of traders have always been used to just punching in the various legs of a trade into a system, and moving on to the next thing. There is no doubt that in many ways, a computer can process legging orders better than a human:
    * order execution is almost instantaneous (milliseconds for a computer vs seconds for a human)
    * there is less risk of error. I have seen my share of “fat finger” order processing errors.
    * the computer doesn’t need to take breaks to use the bathroom, go get food, or use the phone.
    … just to name a few of the major reasons.

    But there is an art to legging a trade, and I think the convenience of just being able to “punch it in” has made people not think about all the nuances of legging various structures. There are times when a human will outperform a legging trading system. So I will attempt to discuss some of the factors involved in developing a better understanding of the art of legging.

  • Curve Advisor
    Keymaster
    Post count: 612

    For illustrative purposes, let’s discuss legging the U8 1 year double fly (Buy U8-U9-U0 fly vs Sell U9-U0-U1 fly). This double fly trades as a structure on Globex (“GEU18:U19:U20:U21[DF]”). This is the direct way to work the trade.

    However, there may be times when you may be able to get filled in other ways. Here are some other ways to work this trade via legging:

    Leg a Buy U8-U9-U0 fly vs Leg a Sell U9-U0-U1 fly
    Leg a Buy U8-U1 3 year spread vs Leg a Sell 3x U9-U0 1 year spread

    You punch those legs into TT (or similar legging program), in addition to the main order, and you’ve done all that you can to try and get some of this trade exposure on, right?

    Nope. Try again.

    [cue Jeopardy music]

  • Curve Advisor
    Keymaster
    Post count: 612

    As previously mentioned, the two main ways of legging a double fly trade are: (1) fly to fly, and (2) spread to spread.

    1. FLY TO FLY:
    Many times, you are interested in taking a particular view on a particular part of the curve. The exact contracts aren’t as important as the part of the curve you are taking a view on.

    a) Typically, I will suggest “standard” double fly trades (with overlapping middle spreads) based on ease of execution (offered as a package on Globex, and ability to work in multiple ways). However, a standard double fly may not be the best representation of a trade. It may be that the optimal execution will be two year flies that are 15 or 18 months apart, rather than the standard 12 months. Take a good look at the fly curve and determine which points seem to contain the most value. It may be that the U8 1 year fly vs the Z9 1 year fly offers at least as much value as U8 vs U9. If you are legging fly to fly, you can look for value in these legs as well. In particular, if you are indifferent as to whether you want to leg between U9 and Z9 on the back leg, you can be more aggressive with your U8 leg if you see bids in EITHER of the U9 or Z9 fly legs.

    b) You can represent a curvature view in more ways than just a 1 year fly. It may be that you think a 6 month fly offers more value than the 1 year fly. So rather than buy the U8 1 year fly, you may want to buy 4x as many H9 6mo flies vs selling the U9 1 year fly. You can even buy 1.78x a 9mo fly vs selling the U9 1 year fly. See the “Decomposing Flies” thread if you don’t understand why.

    The main point is – don’t be constrained by the structure. What you should care more about is not the structure itself, but the curvature exposure in your book.

  • Curve Advisor
    Keymaster
    Post count: 612

    2. SPREAD TO SPREAD

    This is where you can get a lot of volatility and where a missed leg by your auto-legger can be costly. The flies tend not to move very quickly. However, the spreads can be a different story. But where there is volatility and risk, there is also opportunity.

    The thing that could make trading spread to spread more favorable is that double fly trades are leveraged to the middle leg. That is, on a standard double fly, you need to do 3x as many of the middle spread vs 1x as many of the outer spread. So in tightly rangebound markets, if you can pick up 1/4 bp on the middle leg (sell at the offer or buy on the bid), you are picking up 3/4bps on the structure. Depending on where you see the middle of the outside leg (you should use not only the bid/offer on the spread market (which can be wide), but also a weighted measure of the individual contracts), you can try working bids or offers on the middle leg. If you are going to try and work the double fly trades as spread to spread, it helps to have a slope view on the curve.

    Also, you don’t have to be married to working a 1 year spread as the middle leg. If a particular 6 month spread offers more value, you can buy 2x as many 6mo spreads as the 1 year spread. OR you can buy 1.33x as many 9mo spreads. In our example, rather than working U8-U1 vs 3x U9-U0, you can work U8-U1 vs 6x Z9-M0 spread. Again, don’t be constrained by the actual contracts – think more about the steepening / flattening exposures you are trying to put on in your book. When you start considering trades in the whites or reds, it becomes more important to pay attention to the details.

  • Curve Advisor
    Keymaster
    Post count: 612

    Here are the two main things to keep in mind when legging: [I may add to this]

    1) KNOW THE COMPONENTS. You need to know not only the trading range and trading characteristics of the double fly, but also the trading range and trading characteristics of the individual components. So when you know one of the legs is bumping against what you think may be support or resistance, or you think there may be some demand/supply factors at particular levels, use that information to your advantage. You may be able to get more fills, or fills at better levels.

    2) KNOW THE IMPORTANT LEG. Many times, one leg will be more important than the other, for various reasons. In the case of legging spread to spread, you need 3x as many of the middle spread than the outer spread. So getting a great fill on the middle leg can help you get a great fill on the entire structure. One leg may be less liquid than another leg, so getting the less liquid leg could be more important. One leg may contain “most” of the value. Also, one leg may fit better into your book. Think about your portfolio’s risk exposure and ask yourself which one would fit better. That may be one of the factors that cause you to prefer one leg over the other.

    These are all factors that an autolegger would not take into account, but you can!

  • Curve Advisor
    Keymaster
    Post count: 612

    Your state-of-the-art trading system may be costing you money. Here is one way that technology can make trading less profitable. Before you put a trade into a legging program, consider whether it would be more profitable to manually leg the trade. For example, say you are trying to leg a double fly. Here is the market:
    U7-U8-U9 fly:
    Bid/Ask: 0/0.5; Size: 500/500
    U8-U9-U0 fly:
    Bid/Ask: -1.5/-1; Size: 5,000/500
    Let’s say you want to buy the U7 1yr double fly (buy U7 1yr fly and sell U8 1yr fly) @ 1.5. If you punch the order into the legger, it will work a bid in the U7 fly and an offer in the U8 fly to try and leg it. But consider what happens when you get filled on the bid in the U7 fly. The legger will automatically sell the U8 1 year fly. This is okay if the markets are moving fast, or you are busy doing more important things. But did you really need to hit the bid when where there is 5,000 on the bid? There is a reasonably high probability the offer would have traded on the U8 1 year fly. So you may have been able to buy 1s in the double fly, rather than buying at 1.5. A half bp may not seem like a lot, but a half bp a day on a 100 lot is over $300K a year. Sometimes you miss a leg, or end up hitting the bid anyway. But it all adds up over time.

  • Curve Advisor
    Keymaster
    Post count: 612

    Recently, an interesting legging situation came up. We were long the H7 1 year double fly (buying the H7-H8-H9 fly vs selling the H8-H9-H0 fly). When we attempted to take profit, the H7 1yr fly wouldn’t quite trade 1, and the H8 1yr fly wouldn’t quite trade -2.5 as a fly on Globex. This made taking profit on the trade almost impossible. So what to do?

    In a previous post, I mentioned that you should know the important leg. In this case, the key leg would be the H8-H9 spread – it helps you: (1) sell H7 1yr fly, (2) buy H8 1 yr fly, and (3) if you leg H7-H0 spread vs 3x H8-H9 spread, you can leg out of the double fly. Unfortunately, the H8-H9 spread was closer to 15, which did not help us leg out of at our desired levels.

    You should always be aware of everything else that is going on in the curve. At the time H8-H9 was 15, the Z7-Z8 spread was closer to 14.5. If you look at the spread curve, the 1yr spreads start rising as they get closer to the front of the curve. And with my view of the curve, I preferred owning the Z7-Z8 spread than the H8-H9 at a similar price. So it made sense to replace H8-H9 with Z7-Z8 with all the unwinds. I would be able to take a 0.5 bp profit on the (Z7-Z8 vs H8-H9) structure at some point. But even if I had to scratch the two spreads, that still would have been a good result, as it allowed me to take some profit off the table when I wanted to.

    So next time you are close on something, take a look at the curve around you… sometimes an adjoining structure, or alternate structure (like 2x a 6mo spread, etc) may allow your to exit better.

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