The strap straddle falls into the category of an options trading strategy for a volatile market, it's designed to return a profit when the price of a security makes a substantial move. Unlike most similar strategies, which are typically designed to be used when you cannot determine which direction the price of the security will move in, this one is specifically for you: if you believe there is a greater likelihood of a significant price increase than a significant price drop.
This is essentially a modified long straddle where instead of buying an equal amount of call options and put options you buy a higher amount of calls. We have provided details of this strategy below, but we would advise that you only study this strategy if you are already familiar with the long straddle. If you aren't, then please take a look atthis page first.
The Key Points
- Volatile Strategy (with bullish inclination)
- Suitable for Beginners
- Two Transactions (buy calls and buy puts)
- Debit Spread (upfront cost)
- Is also known simply as the Strap
- Low Trading Level Required
When & How to Apply the Strap Straddle
As we have mentioned above, the strap straddle is designed specifically to be used when you have a volatile outlook with a bullish inclination. This means that you should use it if your expectation is that the underlying security will make a significant price movement in either direction, with an upward price movement being the most likely direction. It can return a profit from either direction, but the profits will be greater if the underlying security does indeed go up substantially.
Just like the long straddle, the strap straddle also requires you to buy at the money calls and at the money puts, with the same expiration date. However, you need to buy more calls than puts. You'll need to decide what ratio of calls to puts you use; we would advise a 2 to 1 ratio when you start using this strategy and then making any adjustments depending on the circumstances and your outlook.
Example of the Strap Straddle
We have provided an example of using the strap straddle below, including what the results would be based on different price movements in the underlying security. Rather than using exact market data, we have used hypothetical options prices, to keep things simple. For the same reason, we haven't included commission charges.
- Company X stock is trading at $50 and you believe the price will make a significant move. You also think that an upward movement is most likely.
- At the money calls (strike $50) are trading at $2. You buy 2 contracts of these (each contract containing 100 options), at a cost of $400. This is Leg A.
- At the money puts (strike $50) are trading at $2. You buy 1 contract of these, at a cost of $200. This is Leg B.
- You have created a strap straddle for a net debit of $600.
- If Company X stock is still trading at $50 by the time of expiration, then the options in both legs will expire worthless and you will lose the $600 you have invested.
- If Company X stock is trading at $53 by the time of expiration, then the calls in Leg A will be worth $3 each ($600 total) while the puts in Leg B will expire worthless. You will have broken even, as the value of the calls is equal to the initial investment.
- If Company X stock is trading at $57 by the time of expiration, then the calls in Leg A will be worth $7 each ($1400 total) while the puts in Leg B will expire worthless. Taking into account the initial investment of $600, you will have made a profit of $800.
- If Company X stock is trading at $47 by the time of expiration, then the calls in Leg A will expire worthless while the puts in Leg B will be worth $3 each ($300 total). You will have made a loss of $300, as the value of the puts is less than the $600 initial investment.
- If Company X stock is trading at $43 by the time of expiration, then the calls in Leg A will expire worthless while the puts in Leg B will be around $7 each ($700 total).You will have made a total profit of $100, taking into account the initial investment.
Profit, Loss & Break-Even Calculations
The following apply to the strap straddle trading strategy.
- Maximum profit is unlimited and profit is made when “Price of Underlying Security > (Strike + (Price of Each Option in Leg A / Ratio of Calls to Puts) + (Price of Each Option in Leg B)” or when “Price of Underlying Security < (Strike– (Price of Each Option in Leg A x Ratio of Calls to Puts) - Price of Each Option in Leg B)”
- The strap straddle has an upper break- even point and a lower break-even point.
- Upper Break-Even Point = “Strike + (Price of Each Option in Leg A / Ratio of Calls to Puts) + Price of Each Option in Leg B”
- Lower Break-Even Point = “(Strike – (Price of Each Option in Leg A x Ratio of Calls to Puts)) – Price of Each Option in Leg B”
- The strap straddle will return a loss if “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
- Maximum loss is limited to the initial investment and occurs when “Price of Underlying Security = Strike Price”
Although the strap straddle is a little more complicated than the basic long straddle (and other similar strategies such as the long strangle and the long gut), if you are confident that an upward price movement is more likely than a downward price movement, then it will usually be a strategy well worth considering.
It's suitable strategy for beginners, because there are only two transactions and no margin requirements.