Advanced Option Strategies/Bullish Strategies

Studying Straps

Andrea Kramer (akramer@sir-inc.com)

Straps are among several options strategies designed for traders expecting significant price swings. The strap is a cousin of the long straddle, but while the straddle is technically neutral, the strap is more bullishly aligned.

Review

Before we begin, let�s go over the basics of a long straddle position. In anticipation of a big move in the stock price (ahead of an earnings report, perhaps), many traders will initiate a straddle by purchasing an equal number of at-the-money puts and calls with the same strike and same expiration. The investor�s risk is limited to the premium paid for the two options, and profit is attainable if the shares make a monster move in either direction ahead of expiration.

Strap In

On that note, the strap is a slightly more bullish version of the long straddle, as the trader is predicting the underlying security is more likely to power higher instead of declining. With the strap, the investor would purchase one at-the-money put on the stock, while simultaneously buying two at-the-money calls with the same strike and expiration.

Like the straddle, there are two breakeven points for the strap: the strike minus the net premium paid, and the strike plus the net premium paid. The trader would still profit if the equity breaches either of the breakeven levels before expiration, but stands to make more money if the stock advances.

For Example

For instance, let�s assume that John is following Company XYZ, which is expected to report earnings soon. He�s confident that the shares of XYZ will respond in dramatic fashion, but he thinks the odds are greater for the stock to rally rather than decline. With this in mind, John opts to initiate a strap, as opposed to the common straddle.

Ahead of earnings, the stock is flirting with the $80 level. As such, John buys one XYZ August 80 put for $1, but purchases two XYZ August 80 calls for $2 each, or $4 total. The net debit on his position would then be $5 ($1 + $4), making this the most he stands to lose.

In order to avoid a loss on the position, John needs the shares of XYZ to breach one of two levels: $75 (strike � net debit) or $85 (strike + net debit) by options expiration on Friday, Aug. 21. However, since he purchased twice as many calls than puts, John stands to make more on the position of the stock rallies.

Now, let�s assume the company reported weaker-than-expected earnings, sending XYZ to the $60 level by expiration. The August 80 calls will expire worthless, but the August 80 put will hold an intrinsic value of $20, as it will be in the money by 20 points. Minus the net debit of $5 (and not including any brokerage fees), John�s strap position would bank a profit of $15.

On the other hand, let�s say the firm�s quarterly figures exceeded the Street�s forecast, fueling XYZ to the $100 level by expiration. The August 80 put would expire worthless, but the two August 80 calls would hold an intrinsic value of $20 each, or $40 total. Subtracting the $5 paid to purchase the options (and not including any brokerage fees), John�s strap position would bank a profit of $35.

In Conclusion�

Straps are best suited for traders expecting the stock to make a significant move on the charts, but think the odds are greater for the equity to power higher rather than decline. The premium paid � and, ultimately, the maximum potential loss � for this option play will be more than that of the straddle, though, as the investor would be purchasing more options at the start. However, as you can see by the aforementioned example, the potential reward if the stock ticks higher may be worth it.