What it means
A call option gives the right to buy a share at a fixed strike price, and a put option gives the right to sell at that price. A strap holds two calls and one put, so it is a bet on volatility, meaning the size of price swings, with a bullish tilt.
It is a variation of the straddle, which holds one call and one put. Because the investor buys three options, the upfront cost is higher than for a straddle, and all of it is at risk.
The maximum loss occurs if the share price finishes exactly at the strike, where all three options expire worthless. The loss is limited to the total premium paid.
The strategy makes money when the share price moves far enough from the strike to cover that premium. On the upside, each call gains in value, and since there are two, profit grows twice as fast.
On the downside, the single put gains at a slower rate, so a larger fall is needed to break even. Investors use a strap before events that could cause a big move but where direction is uncertain, such as earnings, regulatory decisions or a takeover vote.
The risk is that the market already expects a large move, which is built into option prices through implied volatility. If the actual move is smaller than expected, the strap loses money even if the direction was right.
Listed options usually cover 100 shares per contract, so one strap is made up of two call contracts and one put contract, covering 100 shares each. Trading costs and the wide spreads on options can eat into the profit, so liquid contracts are preferred.
The strategy suits experienced investors who understand the risks.
In practice
Real-world examples.
Example
A trader expects a pharmaceutical company's drug trial result to cause a big move, and thinks approval is more likely than rejection. She buys a strap on the shares before the announcement. If the news is good, her two calls pay off strongly.
Example
An analyst uses a strap before a technology company's results. The cost is $1,100 and the share price is $100. If the results lift the price to $112, the profit is 2 x 12 - 11 = $13 a share, or $1,300 per strap.
Example
A cautious investor considers a strap but sees that the options are expensive because the market already expects a big move. He calculates that the shares must rise past $105.50 or fall below $89 just to break even. He decides the odds are not good enough and does not trade.
Formula
Calculation
Profit at expiry = 2 x (share price - strike, if positive) + (strike - share price, if positive) - total premium paid
Upper break-even = strike + (total premium / 2), and lower break-even = strike - total premium
An investor buys 2 calls at a $4 premium and 1 put at a $3 premium, all with a $100 strike. Total premium per share = 2 x 4 + 3 = $11, which is 11 x 100 = $1,100 per strap. Upper break-even = 100 + 11 / 2 = $105.50. Lower break-even = 100 - 11 = $89. If the share finishes at $110, profit per share = 2 x 10 - 11 = $9, or $900. If it finishes at $90, profit per share = 10 - 11 = -$1, a loss of $100.Case study
Seen in the real world.
Redwood Biotech is an illustrative, fictional company trading at $100 ahead of a regulatory decision on its main product. A private investor believes approval is likely but is unsure about the market reaction, so she buys five straps with a $100 strike for $11 per share each, costing 5 x 1,100 = $5,500.
If the product is approved and the shares rise to $120, each strap pays 2 x 20 = $40 a share, so the profit per strap is (40 - 11) x 100 = $2,900. Across five straps, that is $14,500. If the decision is rejected and shares fall to $80, each strap pays $20 from the put, and the profit per strap is (20 - 11) x 100 = $900, or $4,500 over five.
In this illustrative case, the shares barely move and finish at $102, so the calls pay 2 x 2 = $4 a share and the strap loses 11 - 4 = $7 a share, or $3,500 over five straps. The lesson is that a strap needs a big move to pay, and that the premium is the price of the bet.
Watch out
Common mistakes.
- Buying a strap when the market already expects a large move, when high option prices mean the shares must move even further to profit.
- Forgetting that all three options can expire worthless, which makes the full premium a real risk.
- Confusing a strap with a strip, when a strap has two calls and one put while a strip has two puts and one call.
Questions
People also ask.
What is the difference between a strap and a straddle?
A straddle holds one call and one put, while a strap holds two calls and one put, which tilts it towards a price rise.
When does a strap make money?
It makes money when the share price moves far enough from the strike, in either direction, to cover the total premium, with profit growing faster on the upside.
What is the maximum loss on a strap?
The maximum loss is the total premium paid, which occurs when the share finishes exactly at the strike price at expiry.
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