The “strap” denotes a market-neutral options trading strategy with profit potential on either side of 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 an efficient market neutral strategy, while the strap is a “bullish” market neutral strategy that generates double the profit potential on upward price movement compared to equivalent downward movement. (Want to know more about "market neutral"? See "Getting Results with Market-Neutral Funds.")
Strap options offer unlimited profit potential on upward price movement 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 is high because 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 security, at the same strike price and expiration date. The underlying can be any optionable security, i.e. a stock like IBM or an index like SP-500.
Strap Payoff Function
Let's create a strap on a stock currently trading around $100. Since we're buying ATM options, the strike price for each option should be near the underlying price i.e. $100.
Here are 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 (costing $7). We’ll take price (option premiums) into consideration at the last step.
Now, let’s add these positions together to get the 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 created by this position. Hence, the net payoff function (turquoise graph) will shift down by $20, giving us the brown net payoff function with prices taken into consideration:
Strap Profit & Risk Scenarios
There are two profit areas for strap options i.e. where the payoff function remains above the horizontal axis. In this example, the position will be profitable when the underlying moves above $110 or drops below $80. These are known as breakeven points because 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
Strap Profit and Risk Profile
The trade has unlimited profit potential above the upper breakeven point because, theoretically at least, price can rally to infinity. For each point gained by the underlying security, the trade will generate two profit points – i.e. a one dollar increase in the underlying increases the payoff by two dollars.
This is where the bullish outlook for strap plays offers better profit on upside compared to downside and how the strap differs from a straddle that offers equal profit potential on either side.
The trade has limited profit potential below the lower breakeven point because the underlying cannot drop below $0. For each point lost by the underlying, the trade will generate one profit point.
Profit in Strap 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 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 payoff function lies below the horizontal axis. In this example, it lies between these two breakeven points and will incur a loss when the underlying remains between $80 and $110. The loss will vary linearly depending upon on the underlying price.
Maximum Loss in Strap Trading = Net Option premium paid + Brokerage & Commission
In this example, maximum loss = $20 + Brokerage
The Bottom Line
The strap strategy offers a good fit for traders seeking to profit from high volatility and underlying price movement in either direction. Long-term option traders should avoid straps because they will incur considerable premium generated by time decay. As with all trading strategies, keep a clear profit target and exit the position when the target is reached. Although the stop loss is already built into the position due to the limited maximum loss, traders should also watch stop loss levels generated by underlying price movement and volatility.