A strap or a long strap is a multi-legged, neutral to bullish strategy. In this strategy,
the risk is defined. The strategy is made up of buying two long calls and one with the
same strike price and expiry date. The strategy can be very beneficial if the underlying
stock's price rises regardless of the direction and if the stock faces high volatility.
The strap is similar to the long straddle, except with more legs; the straddle has one,
while the strap has two. More legs make it expensive to enter but also more profitable.
The two long calls in this strategy make it a bullish bias, but at the same time needs
the underlying stock to move significantly in one direction. The move must be higher
than the long straddle as it has to cover the cost of three long options. A sharp
movement in any direction will give you double the profit.
Another strategy, named strip strategy, is reverse to strap and neutral to bearish. In
this strategy, two long puts and one long call are bought together, having the same
strike price and expiry date.
A long strap from the market's perspective:
Though the Long straps are bullish, they can make a good profit if the underlying
stock price moves in either direction. In order to cover the combined break-even
point of three long options, the strap strategy must make a good move. Long straps
need a significant price movement or high volatility before their expiry to make
some profit.
A rise in implied volatility also leads to large movements in stock prices. It is beneficial
to the strap, as the strategy is highly dependent on both; a rise in the price movement
and a rise in volatility. It will help the trader to collect the high premiums while exiting
from the trade.
How can I set up a long strap?
A long strap is created by buying two long call options and one long put option, all with the same strike price and expiry date. Straps are generally purchased at-the-money price of the underlying stock.
The total cost after combining the long calls and long pulls is the highest risk on this
trade for any trader. The long strap will benefit from the significant move in an upward
or downward direction or implied volatility, though the upwards movement might be
much more profitable. If the price moves upwards, the profit potential is limitless and
beyond the debit paid at entry.
Understanding the diagram of the strap:
The diagram of the long strap looks like a slightly skewed V shape, in which the call
side gains more profit. The highest loss is predefined while entering into the trade by
the total cost of three options contracts. The potential to make a profit in this strategy
is unlimited if there is a large move in one direction before expiry. The net profit in this
strategy would be credit gain upon closing or exiting the trade minus the premium
paid for purchasing the contracts. The break-even point is the total cost of all three
contracts above or below the strike price.
For example: if a trader has purchased a long strap by paying Rs. 10 as a premium
at the strike price of Rs. 50, then the stock must close either above Rs. 60 or below
Rs. 40 to make the maximum profit.
How can I enter the long strap?
The long strap is made with two long calls and a long put bought together at the
same strike price and same expiry date. Let's say, for example, a trader expects a
stock of Rs. 50 to experience high volatility before its expiry; in this case, the trader
can enter the strap by buying the two call options at Rs. 50 and one long put option
at Rs. 50. The rise in volatility will lead to the high prices of options. The more time the
contract has to expire, the more costly it will become.
How can I exit from a long strap?
As we have seen, when there is a significant upwards/downward move in the stock
price or high volatility, this strategy can be very beneficial. If the stock price has
moved far or there is high volatility, the trade can be exited by sell-to-close(STC) of
all three options contracts. The difference gained in purchasing and selling all three
options contracts would be either net profit or loss to the trader on this trade.
One of the options might be in-the-money at the time of expiry and requires exit to
avoid its execution. Generally, traders exit the straps before they expire in order to
utilize their remaining intrinsic value.
The impact of the time decay factor on the Long strap:
The time decay or theta does not work in favor of the long strap, instead works against
it. With each passing day, the value of the contracts decreases. A large shift in the
value of the long position may occur but for a short time. Traders need to keep an eye
on the price shift and sell the options as soon as they see a shift in the price.
Impact of Implied volatility on the long strap strategy:
Long strap strategies are profitable when there is high implied volatility. An increase
in volatility leads to high premiums on the options. Generally, when the long strap is
initiated, the volatility is low and increases as it approaches the expiry. Though future
volatility is unpredictable, knowing its impact on the position will help you to make
better decisions.
How can I adjust a Strap strategy?
The straps have a good amount of time to be profitable; also, many factors are
working against its success. Suppose the underlying stock price has not moved
enough, or if the volatility decreases, the strap will lose its value and result in a loss.
Similar to the other strategies, straps can also be adjusted, but they will cost traders
extra money and will also raise the break-even point.
If the trader does not find the position in a profit zone till the expiry, then the trader can sell the in-the-money options. The other options will be out-of-the-money, of course, as the strap has gone out of the profit zone. Traders may buy the entirely new position for some later expiry date. Traders may even choose to close the position before the expiry to gain some profit instead of allowing the position to expire worthlessly. But please remember, by doing so, the stock will require to move even higher than before, and also, the risk will increase because of the additional funds invested.
How to roll the strap strategy?
Traders can roll the straps to some later expiry date to make a profit in the case when
the price of the stock has not shown any significant changes or if there is no or low
implied volatility. To roll out the strap strategy, traders must sell-to-close (STC) the
entire current position and buy-to-open (BTO) a new position for some later expiry
date. The new strap can be at the same strike price as before or adjusted as per the
stock price change.
The only disadvantage of rolling the strap options is that it will increase the cost of
the overall position and ultimately increase the risk of the position. We can say that
the risk is defined, but the extra debit paid will increase the loss potential and will also
require the underlying stock to move high to exceed the new break-even point.
Hedging the straps:
Hedging the strap can be a wise choice to retain some gain in a situation where
the stock has shown a sharp movement earlier than expiry. Hedging will minimize
the overall risk of the position. Straps will need a sustained and directional move in
order to make a profit. Sometimes stocks can move upwards quickly and retrace
without leaving a single chance for the traders to profit, and the position often expires
worthless.
If the underlying stock moves in any direction, the trader can select to hedge the
position in the opposite direction of the initial move. Suppose the stock has moved
up, then the trader can roll the position upwards, and alternatively, if the stock has
moved down, the long calls can be rolled down.
For example, if the stock trading at Rs. 50 is purchased by paying a premium of
Rs. 10, and it has faced a sudden upwards movement up to Rs. 55. Then, one method
to hedge this above position is sell-to-close (STC) Rs. 50 put options and buy-to-open
new position at Rs. 55 put options having the same expiry date. This has definitely
added the extra cost to the position, but now, the position cannot be closed at less
than Rs. 5. (the spread width between the call and put options)
Let us say the stock is moving continuously upwards above Rs. 55. The bullish bias of the strap will benefit from additional protection from a higher strike put. Suppose the stock falls below Rs. 50, then Rs. 55 strike put will trade no less than Rs. 5. This is the way to minimize the risk and gain profit if the stock keeps moving in one direction.
In order to hedge the full strap, the value of the long options should be equal. If we
consider the same example as above, then the trader may buy one extra putt option
or sell one call option. If traders choose to sell the call option, they may realize some
extra profit, which will help reduce the risk on the position. Whereas, if traders prefer
to buy an extra put option contract, they need to invest additional money, which will
increase the overall cost of the position and give rise to more risk. But remember, it
can also make a high profit if the stock moves drastically low.
So, this was all about the Strap options strategy, how you can enter, exit, roll, and
hedge. If you still have any questions, please contact us directly at the number
provided and get your queries solved.