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A Market Neutral Bullish Strategy

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.

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.

Strap Construction

The cost of constructing the strap is high because it requires three options purchases:

  1. Buy 2 ATM (at-the-money) call options
  2. 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 the price (option premiums) into consideration at the last step.

Image by Julie Bang © Investopedia 2020

Now, let’s add these positions together to get the net payoff function (turquoise color):

Image by Julie Bang © Investopedia 2020

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:

Image by Julie Bang © Investopedia 2020

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.

Image by Julie Bang © Investopedia 2020

In general:

  • 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, the 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 the 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 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.

Thiru Venkatam: Thiru Venkatam is a distinguished digital entrepreneur and online publishing expert with over a decade of experience in creating and managing successful websites. He holds a Bachelor's degree in English, Business Administration, Journalism from Annamalai University and is a certified member of Digital Publishers Association. The founder and owner of multiple reputable platforms - leverages his extensive expertise to deliver authoritative and trustworthy content across diverse industries such as technology, health, home décor, and veterinary news. His commitment to the principles of Expertise, Authoritativeness, and Trustworthiness (E-A-T) ensures that each website provides accurate, reliable, and high-quality information tailored to a global audience.
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