The strap is a modified, more bullish version of the common straddle. It involves buying a number of at-the-money puts and twice the number of calls of the same underlying stock, striking price and expiration date.
Buy 2 ATM Calls, Buy 1 ATM Put
Straps are unlimited profit, limited risk options trading strategies that are used when the options trader thinks that the underlying stock price will experience significant volatility in the near term and is more likely to rally upwards instead of plunging downwards.
Unlimited Profit Potential
Large profit is attainable with the strap strategy when the underlying stock price makes a strong move either upwards or downwards at expiration, with greater gains to be made with an upward move.
Unlimited
Profit achieved when: Price of Underlying > Strike Price of Calls/Puts + (Net Premium Paid/2) OR Price of Underlying < Strike Price of Calls/Puts - Net Premium Paid
Profit = 2 x (Price of Underlying - Strike Price of Calls) - Net Premium Paid OR Strike Price of Puts - Price of Underlying - Net Premium Paid
Limited Risk
Maximum loss for the strap occurs when the underlying stock price on expiration date is trading at the strike price of the call and put options purchased. At this price, all the options expire worthless and the options trader loses the entire initial debit taken to enter the trade.
Net Premium Paid + Commissions Paid
Loss occurs when: Price of Underlying = Strike Price of Calls/Puts
Breakeven points
Strike Price of Calls/Puts + (Net Premium Paid/2)
Strike Price of Calls/Puts - Net Premium Paid
Example
Suppose XYZ stock is trading at $40 in June. An options trader implements a strap by buying two JUL 40 calls for $400 and a JUL 40 put for $200. The net debit taken to enter the trade is $600, which is also his maximum possible loss.
If XYZ stock price plunges to $30 on expiration in July, the JUL 40 calls will expire worthless but the JUL 40 put will expire in-the-money and possess intrinsic value of $1000. Subtracting the initial debit of $600, the strap's profit comes to $400.
If XYZ stock is trading at $50 on expiration in July, the JUL 40 put will expire worthless but the two JUL 40 calls expires in the money and has an intrinsic value of $1000 each. Subtracting the initial debit of $600, the strap's profit comes to $1400.
On expiration in July, if XYZ stock is still trading at $40, both the JUL 40 put and the JUL 40 calls expire worthless and the strap suffers its maximum loss which is equal to the initial debit of $600 taken to enter the trade.
Commissions
These examples exclude commissions and fees. Include all transaction costs when evaluating the profit or loss of a position.
Similar strategies
Strip
The strip is a modified straddle that has a bearish bias on the profit/risk potential.