Strap Options: A Market Neutral Bullish Strategy

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Strap Options: A Market Neutral Bullish Strategy

The term “strap” refers to a market-neutral options trading method that may benefit on either side of a price fluctuation. Straporiginated from a somewhat modified kind of astraddle. A straddle has equal profit potential on each side of underlying price movement, making it an efficient market neutral strategy, but a strap is a “bullish” market neutral strategy that creates double the profit potential on upward price movement compared to corresponding downward movement.

Strap options provide infinite profit potential on price increases and limited profit potential on price decreases. The maximum risk/loss is the entire option price paid plus brokerage and fee.

Strap Construction

The cost of creating the strap is considerable since three choices must be purchased:

  1. Purchase two ATM (at-the-money) call options.
  2. Purchase one ATM (at-the-money) put option.

All three options should be purchased with the same underlying security, strike price, and expiry date. The underlying may be any optionable asset, such as an IBM stock or an index such as the S&P 500.

Strap Payoff Function

Let’s make a strap for a stock that is now trading at $100. Because we’re purchasing ATM options, the strike price for each option should be close to the underlying price, which is $100.

The fundamental payout functions for each of the three option positions are shown below. The overlapping blue and pink graphs indicate the LONG CALL options with a strike price of $100 (costing $6.5 apiece). The yellow graph depicts the LONG PUT option (which costs $7). We’ll examine the price (option premiums) in the last stage.

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Image by Julie Bang © Investopedia2020

Now, add these places to get the net payoff function (turquoise color):

Image by Julie Bang © Investopedia2020

Finally, pricing should be considered. The total cost is ($6.5 + $6.5 + $7 = $20). This position generates a net negative of $20 since all of the options are LONG, i.e. purchases. As a result, the net payoff function (turquoise graph) will move down by $20, yielding the brownnet payoff function with prices considered:

Image by Julie Bang © Investopedia2020

Strap Profit & Risk Scenarios

Strap options have two profit zones, where the reward function stays above the horizontal axis. The trade will be profitable in this case if the underlying climbs above $110 or falls below $80. These are referred to as breakeven points because they are “profit-loss border markers” or “no-profit, no-loss” locations.

Image by Julie Bang © Investopedia2020

In general:

  • UpperBreakevenPoint=Call/Put Strike Price + (Net Premium Paid/2)

= $100 + ($20/2) = $110, for this example

  • LowerBreakevenPoint=Call/Put Strike Price – Net Premium Paid

= $100 – $20 = $80, for this example

Strap Profit and Risk Profile

Above the top breakeven mark, the trade has limitless profit potential since the price may potentially surge indefinitely. The trade will yield two profit points for every point earned by the underlying securities, i.e. a one-dollar rise in the underlying raises the payment by two dollars.

This is where a bullish prognosis for strap plays varies from a spread, which gives equal profit potential on both sides.

Because the underlying cannot go below $0.01, the trade has little profit potential below the lower breakeven point. The trade will yield one profit point for each point lost by the underlying.

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Profit in Strap in Upward Direction= 2 x (Underlying Price – Call Strike Price) – Net Premium Paid – Brokerage & Commission

If the underlying closes at $140, profit Equals 2 *($140 – $100). – Brokerage fee of $20

= $60 – Brokerage

Profit in a downward strap = Strike Price of Puts – Underlying Price – Net Premium Paid – Brokerage & Commission

If the underlying closes at $60, profit = $100 – $60 – $20 – brokerage

= $20 – Brokerage

The Risk-or-Loss zone is defined as the area where the payout function is below the horizontal axis. In this case, it is located between these two breakeven thresholds and will suffer a loss if the underlying continues between $80 and $110. The loss will vary linearly with the underlying price.

Strap Trading Maximum Loss = Net Option Premium Paid + Brokerage & Commission

In this example, maximum loss = $20 + Brokerage

The Bottom Line

The strap method is an excellent choice for traders looking to benefit from strong volatility and underlying price movement in either direction. Straps should be avoided by long-term option traders since they will incur a significant premium due to time decay. Maintain a clear profit objective and exit the position when the target is met, as with other trading techniques. Despite the fact that the stop loss is already built into the position owing to the restricted maximum loss, traders should additionally monitor stop-loss levels caused by underlying price movement and volatility.

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