Ever wonder how to maximize gains from significant market movements? Or is there a strategy that will let you profit from strong upward trends and at the same time protect your investment in case prices fall? Strap options might be what you are looking for. But why strap, and how does it fit into your trading strategy? Let’s dive into this with Options Alert!
What are Strap Options?
A strap options trading strategy is created by taking two call options, and one put option, all with the same strike and expiration date, on the same underlying asset. The trader takes up a strap when expecting a dramatic movement in the underlying asset’s price up or down.
Using Strap Options
The strap option strategy is often used during important events like earnings reports or major news events. For instance, a trader who may feel positive about a company’s long-term prospects but is concerned that the current earnings report underperforms, a trader may hedge potential market volatility with the strap strategy.
The strap strategy’s profit curve is a lot like that of a Straddle. Both are buying call and put options at the same strike price, close to the market price. Because it holds two call options, it is biased bullish, and hence, its profit curve above the price of the underlying asset is steeper, showing higher profit potential when the price goes up.
An important feature of the strap strategy is its unlimited profit potential above the upper breakeven point. When the underlying asset’s price increases, profits grow at a 2:1 ratio. For example, if the asset’s price rises by one dollar, the profit increases by two dollars, providing strong leverage as the price moves up.
The strap strategy has limited profit potential if the asset’s price declines; the put option will help generate some profit to offset part of the cost. However, this profit will not compare to the gains from the call options when the price rises significantly. So, the strap strategy is best suited for traders who expect a strong upward movement in the underlying asset.
How do Strap Options work?
Structure
Buy two call options and one put option with the same strike price and expiration date. This structure results in a net debit, the total premium paid for the position.
Payoff Function
The payoff function for a strap consists of the combined outcomes of the individual call and put options. The net payoff curve represents the overall profit or loss depending on the underlying asset price movement. After considering the premiums paid, the payoff curve will shift to account for the total cost of the position.
Breakeven Points
The strategy has two breakeven points, representing the prices at which the strategy moves from a loss to a profit.
- Upper Breakeven: The price at which the position begins to generate a profit on the upside. Upper Breakeven Point = Strike Price of Call/Puts + (Net Premium Paid/2)
- Lower Breakeven: The price at which the position becomes profitable on the downside. Lower Breakeven Point = Strike Price of Call/Puts – Net Premium Paid
Profit Potential
Unlimited Upside Profit: As the underlying asset’s price rises above the upper breakeven point, the profit potential grows exponentially. For every unit increase in the underlying asset price, the profit will increase by a factor of two (due to two call options).
Limited Downside Profit: If the price falls below the lower breakeven point, the potential profit still exists but at a slower rate, as the position only benefits from the put option.
Maximum Loss
The maximum loss is limited to the total premium paid for the options plus any transaction costs. This loss occurs when the underlying asset’s price remains between the breakeven points.
Risk of Time Decay
Strap options can be costly due to the premiums paid. Time decay erodes the value of the options as expiration approaches, making this strategy more expensive for long-term traders. This strategy is typically used when there is a strong directional outlook, with more potential upside profit than the downside.
Summary
The strap options strategy involves buying two call options, and one put option on the same underlying asset with the same expiration date and strike price. Unlike the more straightforward straddle strategy, where calls and puts are equal numbers, the strap is heavy on call options, reflecting a bullish view. This strategy is invoked when the trader expects an underlier to realize significant price movements, either up or down, but with a more considerable bias toward the upside.
The strap strategy makes a profit from sharp movement in the underlying asset’s price in any direction, especially in a strong bullish trend, given that it involves two calls. Theoretically, a strap offers unlimited profit potential on the upside because there is no restriction on how high the price of the underlying asset can increase. In case of a fall, although the strategy generates a profit, the amount will be less than the one gained in upward movement.
For Example
The investor expects that stock A is going to have huge volatility on the side of an upward trend, so it will use the strap option strategy. The investor will buy two call options and one put option with the same strike price. Assuming the strike price is 100$, the cost of buying two call options is $5 each, totaling $10, and the cost of buying one put option is $4. Therefore, the total cost for this strategy is $14.
This strategy will help the investor maximize profits when stock A rises sharply. When the stock price exceeds $107 (the breakeven point on the upside, calculated as the strike price plus the total cost divided by the number of call options), profits will start to increase significantly due to the two call options.
In case the stock price declines, this strategy can still help offset the initial investment cost with the put option. If the stock price drops below $86 (the breakeven point on the downside), the put option will begin to generate profit, helping to minimize losses.
If the stock price was not highly volatile and was constantly between $86 and $107, the investor would lose as the strategy does not generate enough profit to cover the initial cost. The maximum loss will be $14, which is the total cost of the strategy.
