Fenil's Library

The strategy involves buying two call and one put options on the same underlying stock

Hiral Thanawala

A derivatives strategy that can help investors make the most of a bullish trend is called 'strap', just as there's one called 'strip' for the bears.

A bullish adaptation of the straddle strategy, strap involves buying a number of at-the-money puts and twice the number of calls of the same underlying stock, strike price and expiration date.

This strategy will help earn good profits from equity/ commodity markets when our GDP numbers are stronger; the signs of micro and macro economic stabilisation are prominently visible; profits and sales of companies improvement; and there is increasing participation by the FIIs and HNIs in our markets again.

That's difficult to imagine in the near term, of course, and there's no saying how much longer the bear grip will hold. But, economists expect a clearer picture of economic growth to emerge by the middle of this year, at least for BRIC economies.

So, it is better to understand this strategy now in order to be able to use it when a bull market is upon us again.

This strategy has the potential to create huge profits 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.

Risk:

The risk is limited in this strategy. The 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 net premium and commissions paid to enter the trade.

Computation of breakeven points:

There are 2 breakeven points for the strap option strategy. The breakeven points can be computed as given below:

Upper breakeven point = Strike price of calls/puts + (Net premium paid /2) Lower breakeven point = Strike price of calls/puts - Net premium paid Example: Consider, ABC stock is trading at Rs 1,000 in December. An options trader implements a strap by buying two January calls for Rs 60 per share as premium for a strike price of Rs 1,000 and a January put for Rs 50 per share as premium for a strike price of Rs 1,000. The net debit taken to enter the trade is Rs 17,000, assuming a market lot size of 100 shares.

If ABC stock price reduces to Rs 500 on expiration in January, the January calls will expire worthless, but the January put expires in-the-money and possesses intrinsic value of Rs 50,000 (Rs 500 decline in stock price x 100 lot size). Reducing the initial debit of Rs 17,000, the strap's profit will be Rs 33,000.

If ABC stock is trading at Rs 1,500 on expiration in January, the January puts will expire worthless, but the two January calls expire in the money and have an intrinsic value of Rs 1 lakh (i.e. Rs 50,000 x 2 call options). Reducing the initial debit of Rs 17,000 the strap's profit will be Rs 83,000.

However, if on expiration in January the ABC stock is still trading at Rs 1,000, both the January put and the January calls will expire worthless and the strap will suffer the loss of Rs 17,000, which was paid as premium to enter the trade.

The 2 breakeven points in this case will be:

Upper breakeven point = Rs 1,000 (strike price) + Rs 85 (net premium paid /2) = Rs 1,085.

Lower breakeven point = Rs 1,000 (strike price) - Rs 170 (Rs 60 x 2 call premium + Rs 50 put premium) = Rs 830.

In this example, the stock has to break the price band of Rs 830 to Rs 1,085 to be profitable, i.e. decline below Rs 830 or appreciate beyond Rs 1,085. If the stock price fails to break the price band between the upper and lower breakeven points, the investor will end up losing the entire premium paid for executing this strategy.

Thus, the strap strategy is the right options trading approach for investors who are bullish on the market and expect it to move upwards in near future.

 

This piece first appeared on theApna Paisa Blog, an independentpersonal finance forum.