By Simon Curio
So what the heck is a Layup Spread anyway?
A layup spread is a theta positive option spread trade that sells options far away from the money.
Sorry, let’s try again.
I hope you already know what an option is. But if not, an equity option is a contract that simply allows the holder of the option to buy or sell 100 shares of a stock at a certain price. The option has an expiration date by which is must be used or else it will expire.
Options are used for different reasons. Many options are bought as a hedge. They are used to protect a stock position. Other options are bought for speculation. Many people buy options trying to take advantage of a move in a particular stock.
In other words, people are betting that a stock will move by buying the option.
If they are right, they can make a good return. But most often they are not right.
In order to make money by buying options you have to be correct in 3 ways:
- You have to correctly predict WHICH WAY the stock will move
- You have to correctly predict HOW MUCH the stock will move
- You have to correctly predict WHEN the stock will move
If you can do all three over and over, then you can be a very successful option buyer.
But if you are wrong on any of the three, your options will lose their value and expire.
If you think the stock will go up and it goes down: You Lose
If you think the stock will go up $5 in price and it only goes up $2: You Lose
If you think the stock will go up in price in one month, and instead it takes two months: You Lose.
There are too many ways for option buyers to lose.
That’s why we sell options instead.
Let’s say I think a stock is going to go up in price. I could sell a Put option to take advantage of this. A Put option is an option that increases in value if a stock goes down in price.
So if you think a stock is going down in price, you can buy a Put to try to take advantage.
I am doing the opposite. I think the stock will go up and I want to sell a Put.
When the stock goes up, the Put will lose value and can expire worthless which means I get to keep the entire amount I was paid for the Put.
The stock does not even have to go up. It just has to stay above my Put’s strike price at expiration.
For example, if I sell a 50 strike Put, as long as the stock is trading above $50 at expiration, the Put will be worthless.
But Happens If I Am Wrong?
The above example is a strategy called the Naked Put. It is considered Naked because the option is not protected.
If the stock drops, I could suffer a large loss.
For example if the stock drops to zero, I would still be forced to buy the stock at $50. That leaves me with a $50 per share loss.
Isn’t there a way to guard against that?
A layup spread is a simple option trade in which the trader sells one option and buys another option farther away from the money. This results in a credit to the trader. This credit is the max amount that can be made on the trade and is deposited into the traders account as soon as the trade is made.
The bought option turns the Naked Put into a hedged position. Now the trade has a known max loss and cannot lose more than that amount no matter how low the stock drops.
Example: XYZ stock is currently trading at 100. A trader feels XYZ is a good candidate for a Put Credit Spread. This trader think XYZ is a great company and the stock is going to continue its uptrend. So he sells one 90 strike Put, and buys one 85 strike Put. The credit he receives is 60 cents.
In this trade the highest premium the trader can keep is 60 cents or $60 because each option is made up of 100 shares. The most the trader can lose is $440. This max loss is also the margin requirement the broker will require to be in the account to make the trade.
We can calculate the margin/ max loss by subtracting the credit from the difference between the strikes. In this case 90-85 = 5. So $5 is the max loss per share. But the trader already got paid .60 per share for the trade so the max loss really is $4.40 per share or $440 per option spread.
We calculate the return on our spread options trade by dividing the potential profit by the amount used for the trade. 60/440 = 13.6% potential return on this trade.
How the Layup Spread Option Trade Makes Money
Ok so now we have the trade. But how does it work?
Since we are short the 90 Put, we want XYZ to stay above 90. If it is above 90 at expiration (30 days in our example) then we get the keep the whole credit. XYZ could go up or it could stay around 100 or even down 10% and the trade still makes money.
Even if XYZ goes below 90, as long as it stays above our breakeven point of 89.40 we still make money.
In our example the trader thought XYZ was not going to go down. But if he thought instead that it was going to drop, he could have done a Call Credit Spread using Call options instead. The idea is the same except that he would not want XYZ to rise above the strike of the call option that he sold.
What’s the Risk?
Does it sound too good to be true? It’s not, but there are risks involved. If you look again at the example above we could make $60 but also lose $440. If XYZ has bad news the stock can drop. It has happened to every stock.
So you have to protect yourself. Notice that a credit spread is made up of two options, one you sell and one you buy. If you did not buy an option your position would be considered naked and your risk could be unlimited. By buying an option we start off by limiting the credit spread risk.
Second, you must have proper money management. If you have a $10,000 account, putting it all in Put credit spreads on IBM would not be a good idea. You need to spread your money around so it is not at risk in the same trade, in the same direction, or in the same month.
Third, you should know what you are going to do when your trade gets into trouble. Proper money and risk management are essential to being a prosperous trader.