What it means
Many professional trades are built from several pieces, each called a leg. In an options spread, for instance, you might buy one option and sell another on the same asset.
The one you sell is the short leg, because you are taking the position of the writer, who is obliged to perform if the buyer exercises. The short leg usually brings in cash.
That cash, called a premium, offsets part or all of the cost of the long leg, so the strategy costs less than buying the long leg on its own. In return, the short leg caps how much you can make, or exposes you to losses if the market moves against you.
The short leg is also where most of the risk sits. If a trader sells an option without any protection, the loss can be large or even unlimited.
By pairing it with a long leg at a different strike price, the trader sets a ceiling on the worst outcome. The term also appears outside options.
In a pairs trade, one leg buys a stock expected to do well and the short leg sells a related stock expected to lag, and in a foreign exchange swap the short leg is the currency being sold. Finance teams care about short legs because they carry margin requirements, meaning the broker asks for cash or collateral as a safeguard.
They also have to be valued separately in the accounts, since the sold side is a liability. Monitoring each leg separately is a basic control in any multi-part strategy.
In practice
Real-world examples.
Example
An options trader at a brokerage builds a bull put spread on a retailer's shares. The short leg is a put sold at a higher strike, and the long leg is a put bought at a lower strike. The premium collected on the short leg more than pays for the protection.
Example
A hedge fund runs a pairs trade by buying an established supermarket chain and selling a weaker competitor. The sale of the competitor's stock is the short leg. If both stocks fall in a market slump, the gain on the short leg cushions the loss on the long leg.
Example
A manufacturing company uses a currency swap to convert euro costs into dollars. In the swap the company sells euros at today's rate, and the short leg is the euro-selling side. Treasury tracks the leg separately because its value changes as exchange rates move.
Formula
Calculation
Net premium of a spread = premium received on the short leg - premium paid on the long leg
Suppose a trader sells a put option with a $50 strike for $3.00 per share and buys a put option with a $45 strike for $1.20 per share. The net premium is 3.00 - 1.20 = $1.80 per share, and one contract covers 100 shares, so the trader receives 1.80 x 100 = $180. The maximum loss is the gap between the strikes minus the net premium: (50 - 45 - 1.80) x 100 = $320. The short leg brought in $300 of premium, and the long leg cost $120 to cap the downside.Case study
Seen in the real world.
Brightwater Capital is an illustrative, fictional investment boutique whose analyst proposed buying call options on a shipping company. The calls were expensive, with a premium of $4.50 per share, and the investment committee wanted a cheaper way to take the same view.
The analyst added a short leg by selling a call at a higher strike for $1.50 per share, cutting the net cost to $3.00 per share. The committee accepted that the profit would be capped at the higher strike in exchange for the lower cost.
When the shipping stock jumped far above the higher strike, the fund captured the capped profit but missed the extra upside. The illustrative lesson is that the short leg is what makes the strategy cheaper, and the price of that saving is the profit limit it creates.
Watch out
Common mistakes.
- Looking only at the long leg's cost and forgetting that the short leg creates an obligation that can lose money.
- Assuming the premium received on the short leg is profit, when it can be wiped out and exceeded if the market moves against the trader.
- Closing the long leg early while leaving the short leg open, which turns a limited-risk position into an exposed one.
Questions
People also ask.
Why use a short leg at all?
It brings in premium that reduces the net cost of the strategy, and it lets the trader express a more specific view about where prices will end up.
Does every strategy with a short leg have unlimited risk?
No, pairing it with a long leg usually caps the loss at a known amount, while a short leg on its own, such as a naked call, can carry very large risk.
Is a short leg the same as short selling?
Not exactly, because a short leg can be an option that was sold or a borrowed asset that was sold, while short selling refers specifically to selling borrowed securities.
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