We would categorize the strap strangle as an options trading strategy for a volatile market, because like other comparable strategies, it' s designed to be applied when you have a volatile outlook and are expecting a substantial movement in the price of a security.
However, this strategy will return larger profits if the price of the security goes up than it will if it goes down. This means you should use it when your volatile outlook is coupled with a bullish inclination and you think a price rise is more likely than a fall.
The strap strangle is essentially a long strangle with one significant amendment; you buy a larger amount of calls than you do puts. If you aren't familiar with the long strangle, then we would advise reading this page first. We have provided information on the strap strangle below, but would suggest that only study this strategy once you have understood the long strangle.
- Volatile Strategy (with bullish inclination)
- Suitable for Beginners
- Two Transactions (buy calls and buy puts)
- Debit Spread (upfront cost)
- Low Trading Level Required
When & How to Apply the Strap Strangle
We have already touched on when to apply the strap strangle; when you have a volatile outlook with a bullish inclination. This means you would use it if you are confident the price of the underlying security will move dramatically and believe it's more likely to go up than down. Providing the price moves enough you will make a profit from either direction, but your profits will be greater if the price movement is upward.
This is a straightforward strategy to apply, because there are only two transactions: buying out of the money puts and buying a greater number of out of the money calls options. The decisions you need to make are what strikes to use and what ratio of calls to puts to use.
Neither of these decisions have a defined correct way to go. It's ultimately down to you to decide what is best for the circumstances and your own expectations. In our opinion, when you are first using the strap strangle you should probably use a 2 to 1 ratio (i.e. buy twice as many calls as you do puts). This keeps things simple and you can always adjust the ratio as you gain some experience using the strategy.
In terms of strikes, we would advise buying options that are only just out of the money (i.e. the strikes are close to the current trading price of the security). You should make sure that the strikes you use are an equal distance from the current trading price of the security too.
Example of the Strap Strangle
Below is an example of how you could establish a strap strangle, along with the results in some hypothetical circumstances. We have used rounded prices, rather than precise market data, for the sake of keeping the example easy to understand. For the same reason we have not included any commission charges you may incur.
- Company X stock is trading at $50 and you believe the price will make a significant move, probably in an upward direction.
- Out of the money calls (strike $51) are trading at $1.50. You buy 2 contracts of these (each containing 100 options), at a cost of $300. This is Leg A.
- Out of the money puts (strike $49) are trading at $1.50. You buy 1 contract of these, at a cost of $150. This is Leg B.
- You have created a strap strangle for a net debit of $450.
- 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 $450 spent upfront.
- If Company X stock is trading at $52 by the time of expiration, then the calls in Leg A will be worth $1 each ($200 total) while the puts in Leg B will expire worthless. The $200 value of the calls is lower than the $450 net debit, so you will make a loss of $250.
- If Company X stock is trading at $58 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. The $1400 value of the calls is greater than the $450 net debit and you will have made a $950 profit overall.
- If Company X stock is trading at $48 by the time of expiration, then the calls in Leg A will expire worthless while the puts in Leg B will be worth $1 each ($100 total). The $100 value of the puts is lower than the $450 net debit, so you will make a loss of $350.
- If Company X stock is trading at $42 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). The $700 value of the puts is greater than the $450 net debit, so your profit will be $250.
Profit, Loss & Break-Even Calculations
The following apply to the strap strangle strategy :
- Maximum profit is unlimited and profit is made when “Price of Underlying Security > (Strike of Leg A + (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 of Leg B – (Price of Each Option in Leg A x Ratio of Calls to Puts) – Price of Each Option in Leg B)”
- The strap strangle has an upper break- even point and a lower break-even point.
- Upper Break-Even Point = “Strike of Leg A + (Price of Each Option in Leg A / Ratio of Calls to Puts) + Price of Each Option in Leg B”
- Lower Break-Even Point = “Strike of Leg B – (Price of Each Option in Leg A x Ratio of Calls to Puts) – Price of Each Option in Leg B”
- The strap strangle will result in 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 of Leg A and > Strike Price of Leg B ”
The strap strangle is slightly more complex than the basic long strangle, but only because the ratio involved means an extra decision to make with more complicated calculations. It's still relatively straightforward, and we are comfortable recommending it to beginner traders: providing they have a suitable grasp of options trading in general.
We would suggest comparing the strap strangle to the strap straddle (a very similar strategy) before deciding which one would fit your needs best.