“Strap Options” are among the market-neutral trading strategies with profit potential on either side price movement. “Strap” originated as a slightly modified version of a straddle. A straddle provides equal profit potential on either side of underlying price movement (making it a “perfect” market neutral strategy), while the Strap is a “bullish” market neutral strategy providing double the profit potential on upward price move compared to equivalent downward price move. (Want to know more about what "market neutral" means? See "Getting Results with Market-Neutral Funds.")
Strap Options offer unlimited profit potential on the upward price movement of the underlying security, and limited profit potential on downward price movement. The risk/loss is limited to the total option premium paid (plus brokerage & commission).
(Read about the counterpart strategy: Strip Options: A Market-Neutral Bearish Strategy)
The cost of constructing the strap option position is high, as it requires three options purchases:
- Buy 2 ATM (At-The-Money) Call Options
- Buy 1 ATM (At-The-Money) Put Option
All three options should be bought on the same underlying, with the same strike price and same expiration date. The underlying can be a option-able security (usually a stock like IBM or an index like DJIA, the Dow Jones Industrial Average) on which the option is defined.
Payoff function with an example:
Assume creating a strap option position on a stock currently trading around $100. Since ATM (At-The-Money) options are bought, the strike price for each option should be nearest available to the underlying price i.e. $100.
Here are the basic payoff functions for each of the three option positions. The overlapping Blue and Pink graphs represent the $100 strike price LONG CALL options (costing $6.5 each). The Yellow graph represents the LONG PUT option (cost $7). We’ll take price (option premiums) into consideration at the last step.
Now, let’s add all these option positions together, to get the following net payoff function (Turquoise color):
Finally, let’s take prices into consideration. Total cost will be ($6.5 + $6.5 + $7 = $20). Since all are LONG options i.e. purchases, there is a net debit of $20 for creating this position. Hence, the net payoff function (Turquoise graph) will shift down by $20, giving us the Brown colored net payoff function with prices taken into consideration:
Profit & Risk Scenarios:
There are two profit areas for strap options i.e. where the BROWN payoff function remains above the horizontal axis. In this strap option example, the position will be profitable when the underlying price moves above $110, or drops below $80. These points are known as breakeven points as they are the “profit-loss boundary markers” or “no-profit, no-loss” points.
- Upper Breakeven Point = Strike Price of Call/Puts + (Net Premium Paid/2)
= $100 + ($20/2) = $110, for this example
- Lower Breakeven Point = Strike Price of Call/Puts - Net Premium Paid
= $100 – $20 = $80, for this example
Profit and Risk Profile of Strap Option:
Beyond the upper breakeven point i.e. on upward price movement of the underlying, the trader has UNLIMITED profit potential as theoretically the price can move to any level upwards offering unlimited profit. For every single price point movement of the underlying, the trader will get two profit points – i.e. one dollar increase in underlying share price will increase the payoff by two dollars.
This is where the bullish outlook for Strap option offers better profit on upside compared to downside and this is where the strap differs from a usual straddle which offers equal profit potential on either side.
Below the lower breakeven point, i.e. on downward price movement of the underlying, the trader has LIMITED profit potential as underlying price cannot go below $0 (worst case bankruptcy scenario). For every single downward price point movement of the underlying, the trader will get one profit point.
Profit in Strap Option in upward direction = 2 x (Price of Underlying - Strike Price of Calls) - Net Premium Paid – Brokerage & Commission
Assuming underlying ends at $140, then profit = 2 *($140 - $100) - $20 – Brokerage
= $60 - Brokerage
Profit in Strap Option in downward direction = Strike Price of Puts - Price of Underlying - Net Premium Paid – Brokerage & Commission
Assuming underlying ends at $60, then profit = $100 - $60 - $20 – Brokerage
= $20 – Brokerage
The Risk or Loss area is the region where the BROWN payoff function lies BELOW the horizontal axis. In this example, it lies between these two breakeven points i.e. this position will be loss-making when the underlying price remains between $80 and $110. Loss amount will vary linearly depending upon where the underlying price is.
Maximum Loss in Strap Option Trading = Net Option premium paid + Brokerage & Commission
In this example, maximum loss = $20 + Brokerage
Factors to Consider
Strap Option Trading Strategy is perfect for a trader expecting a considerable price movement in the underlying stock price, is uncertain about the direction, but also expects higher probability of an upward price move. There may be a big price move expected in either direction, but chances are more that it will be in the upward direction.
Real life scenarios ideal for Strap Option trading include
- Launch of a new product by a company
- Expecting too good / too poor earnings to be reported by the company
- Results of a project bidding for which the company has placed a bid
A product launch may be a success/failure, earnings may be too good/too bad, a bid may be won /lost by the company – all of which may lead to big price swings uncertain of the direction.
The Bottom Line
The strap option strategy fits well for short-term traders who will benefit from the high volatility in underlying price movement in either direction. Long-term option traders should avoid this, as purchasing three options for long term will lead to considerable premium going towards time decay value which erodes over time. As with any other short term trade strategy, it is advisable to keep a clear profit target and exit the position once target is achieved. Although the stop-loss is already built-in this strap position (due to the limited maximum loss), active strap options traders do keep other stop-loss levels based on underlying price movement and indicative volatility. The trader needs to take a call on upward or downward probability, and accordingly select Strap or Strip positions.