Strap Options: A Market Neutral Bullish Strategy

What Is a Strap Option?

A strap option is a market neutral options trading strategy with a bullish emphasis. That means it offers profit potential regardless of the direction of the underlying security’s price but more so if the market moves up.

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 transaction fees.

Key Takeaways

• A strap option is a trading strategy with the potential for profit whether the security price moves up or down.
• The profit potential is unlimited when the security’s price is moving upward.
• Profit is limited when the price moves downward.
• Loss is limited to the option premium and transaction fees.
• Market neutral refers to the possibility of profit no matter which direction the market moves.

Strap Construction

The cost of constructing the strap is high because it requires three options purchases, all at the money (ATM):

1. Buy 2 ATM call options 
2. Buy 1 ATM put option

All three options should be bought on the same underlying security at the same strike price and with the same expiration date. The underlying security can be any optionable security, e.g., a stock such as IBM or an index such as the S&P 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 ($100).

The first graph below shows the basic payoff functions for each of the three option positions.

The dark and light blue lines represent the two $100 strike price long call options (costing $6.5 each). The green line represents the long put option (costing $7).

We’ll take the price (option premiums) into consideration at the last step.

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

Finally, let’s take prices into consideration. Total cost will be $20 ($6.5 + $6.5 + $7). Since all are long options (that is, they are purchased, not sold), there is a net debit of $20 created by this position.

Hence, the net payoff function will shift down by $20, giving us the net payoff function with prices taken into consideration (the orange line):

Note

Long-term option traders should avoid straps because they will incur considerable premium generated by time decay.

Strap Profit and Risk Scenarios

There are two profit areas for strap options where the payoff function remains above the horizontal axis.

In this example, the position will be profitable when the underlying security’s price moves above $110 or drops below $80. These are known as breakeven points because they are the “profit-loss boundary markers” (also known as the “no-profit, no-loss” points).

Upper Breakeven Point = Strike Price of Call/Puts + (Net Premium Paid/2)

= $100 + ($20/2) = $110

Lower Breakeven Point = Strike Price of Call/Puts – Net Premium Paid

= $100 – $20 = $80

Strap Profit and Risk Profile

The trade has unlimited profit potential above the upper breakeven point because, theoretically, the price can rally to infinity. For each price point gained by the underlying security, the trade will generate two profit points—i.e., a one dollar increase in the underlying security price increases the payoff by two dollars.

This is how the bullish outlook for a strap offers better profit on the upside compared to the downside and how the strap differs from a straddle, which offers equal profit potential on either side.

The trade has limited profit potential below the lower breakeven point because the underlying security price cannot drop below $0. For each price point lost by the underlying security, the trade will generate one profit point—i.e., a one dollar loss increases the payoff by one dollar.

Profit made from price moving up = 2 x (Price of Underlying Security – Strike Price of Calls) – Net Premium Paid – Transaction Cost

Assuming that the price of the underlying security ends at $140, the profit = 2 x ($140 – $100) – $20 – Transaction Cost

Profit = $60 – Transaction Cost

Profit made from price moving down = Strike Price of Puts – Price of Underlying Security​ – Net Premium Paid – Transaction Cost

​Assuming underlying ends at $60, then profit = $100 – $60 – $20 – Transaction Cost

Profit = $20 – Transaction Cost

Risk/Loss

The risk-or-loss area is the region where the payoff function lies below the horizontal axis. In this example, it lies between the two breakeven points.

So the trader incurs a loss when the underlying security price remains between $80 and $110. The loss will vary depending upon the specific underlying price.

Maximum loss in strap trading = Net Premium Paid + Transaction Cost

In our example, the maximum loss = $20 + Transaction Cost

Is a Strap the Same as a Straddle?

A strap is a slightly modified version of a straddle. A straddle provides equal profit potential whether the underlying security’s price goes up or down, making it an efficient market neutral strategy. The strap is a bullish market neutral strategy that generates double the profit potential when the price moves up, compared to an equivalent downward movement.

When Would an Investor Use a Strap Option?

Investors with a bullish view of the market and facing high price volatility may want to consider a strap option due to the opportunity to make a larger percentage profit on the upside as well as some profit on the downside.

Is a Strap Also Called a Triple Option?

Yes, it is. That’s due to the fact that three options are purchased (two calls and one put).

The Bottom Line

The strap options strategy may be a good fit for traders seeking to profit from high volatility and underlying price movement in either direction. 

As with all trading strategies, it’s important to have a clear profit target and to 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 keep an eye on stop-loss levels generated by underlying price movement and volatility.