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Strap

 

Description

         

         

The Strap is a simple adjustment to the Straddle to make it more biased to the  upside. In buying a second call, the strategy retains its preference for high volatility but now with a more bullish slant.

 

As with the Straddle, we choose the ATM strike for both legs, which means the strategy is expensive. We are therefore requiring a pretty big move, preferably with the stock soaring upwards. As such, our risk is greater than with the Straddle, and our reward is still uncapped. Because we bought double the number of calls, our position improves at double the speed, so the break even to the upside is slightly

tighter. The break even to the downside is the strike less the net debit, which is more than the Straddle because weíve bought double the amount of calls.

 

Again the same challenges apply regarding Bid/Ask Spreads and the psychology of the actual trade. Remember that time decay hurts long options positions because options are like wasting assets. The closer we get to expiration, the less time value there is in the option. Time decay accelerates exponentially during the last month before expiration, so we donít want to hold onto OTM or ATM options into the last month.

              

Use the Straddle rules but buy twice as many calls as puts in order to make an adjustment for the Strap.

 

Again, itís important to follow the entry and exit rules (as for straddles), and psychologically speaking, its another tough strategy to play after you are in. Its very easy to find reasons to exit, even though its in breach of your trading plan. But you must remember that you got in for a certain reason (or reasons), and you must stay in until one of your other reasons compels you to exit.

 

Market Opinion

 

Neutral to bullish.

 

P/L

 

Description: C:\avasaramworkspace\avasaramWeb\web\tutorials\options\Strap_files\image001.jpg 

 

 

 

When To Use

 

You use this strategy if you expect a large surge upwards in the stock price. Volatility looks low but you expect it to increase, especially when you think there is a news event or earnings report within two weeks that will affect volatility.

 

Example

 

XXXX is trading at $25.37 on May 10, 2011.

Buy the August 2011 25 strike put at $1.70.

Buy two August 2011 25 strike calls for $2.40.

 

Benefit

 

There is profit it the stock moves either down or up, with limited risk.

 

Risk vs. Reward

 

The risk is the net debit of the bought puts and calls. The reward is unlimited.

 

Net Upside

 

Unlimited upside.

 

Net Downside

 

Net debt paid.

 

Break Even Point

 

Break even up: strike plus half of the net debit.

 

Break even down: strike minus net debit.

 

Effect Of Volatility

 

Positive. High volatility desired.

 

Effect Of Time Decay

 

Negative and accelerating in the final month before expiration, therefore close out trade within the final month.

 

Alternatives Before Expiration

 

If the stock rises, sell the calls to ensure a profit and wait for a retracement to profit from the put.

 

If the stock drops, sell the put to ensure a profit, and wait for a retracement to profit from the calls

 

After a news event, close out the position if there is a profit, or if there is no movement.

 

Alternatives After Expiration

 

Close the position by selling the puts and calls.

 

Hereís a reminder of the rules for trading straddles that you must also apply for  straps:

         

1. Choose your preferred stock price range. Some traders choose stocks between $20.00 and $60.00, but thatís a personal preference.

         

2. Only do a Strap on a stock that is close to making an announcement, such as  the week before an earnings report.

         

3. Buy ATM calls and puts with the expiration at least two months away, preferably three. You can get away with four months if nothing else is available.

         

4. The cost of the Straddle should be less than half of the stocks recent high less  its recent low. By recent, we mean the last 40 trading days for a two-month  Straddle, the last 60 trading days for a three-month Straddle, or the last 80 days for a four-month Straddle. The point here is that the cost of the Straddle should be low in comparison with the potential of the stock to move. If this works with the Straddle, then the Strap can be acceptable.

         

5. Exit within two weeks after the news event occurs. Never hold into the final month before expiration. During the final month, your options will suffer increasing time decay, which we donít want to be exposed to.

         

6. Try to find a stock that is forming a consolidation pattern, such as a flag or  pennant, or in other words where the stock price action has become tighter  and where volatility has shrunk in advance of a big move in either  direction. Typically weíre looking for a pennant within the context of an upward trend.

                

   

 
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