The ‘Strap’ strategy is one that can be beneficial in a bullish market. This is the bullish adaptation of the straddle strategy. It involves buying a number of at-the-money puts and twice that number of calls of the same underlying stock, at the same strike price and expiration date.

This strategy will play a vital role to earn good profits from equity/commodity markets when our GDP numbers are getting stronger, micro and macro economic indicators are stabilizing and improving, profits and sales are increasing, and FII/HNI participation to invest in these markets. In the near term, it seems difficult to implement this strategy since market is in bear mode. But economists expect a clearer picture of economic growth by end of Q2, 2009 for the BRIC (Brazil, Russia, India, China) countries. So, keep the knowledge of this strategy in the mean time and implement it at the right time to gain the advantage - when you are convinced that it is a bull market rally and direction of the market in near term will remain upwards.

Profit Potentiality: This strategy has the potential to create large amounts of profit 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 losses the net premium and commissions paid to enter the trade.

Computation of break-even points:

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

• Upper break-even point = Strike price of calls/puts + (Net premium paid/2)
• Lower break-even point = Strike price of calls/puts - Net premium paid

Example:

Consider, ABC stock is trading at Rs. 1000 in December. An options trader implements a strap by buying two January calls for Rs. 60 per share as premium for strike price of Rs. 1000 and a January put for Rs. 50 per share as premium for strike price of Rs. 1000. The net debit taken to enter the trade is Rs. 17000. Assume market lot size as 100 shares.

If ABC stock price reduces to Rs.500 on expiration in January, the January call will expire worthless but the January put expires in-the-money and possesses intrinsic value of Rs. 50,000 (Rs. 500 decline is stock price x 100 lot size). Reducing the initial debit of Rs.17000 the strap’s profit will be Rs.33000.

If ABC stock is trading at Rs.1500 on expiration in January, the January puts will expire worthless but the January two call expires in the money and has an intrinsic value of 1 lakh (i.e. Rs. 50000 x 2 call options). Reducing the initial debit of Rs. 17000 the strap’s profit will be Rs. 83000.

On expiration in January, if ABC stock is still trading at Rs. 1000, both the January puts and the January call will expire worthless and strap will suffer the loss of the Rs.17000 that was paid as premium to enter the trade.

The 2 break-even point in this case will be:

• Upper break-even point = Rs. 1000 (strike price) + Rs. 85 (Net premium paid /2) = Rs. 1085.
• Lower break-even point = Rs. 1000 (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. 1085 to be profitable i.e. decline below Rs. 830 or appreciate beyond Rs. 1085. If the stock price fails to break the price band upper and lower BEP investors will end up losing the entire premium paid for executing this strategy.

The strap strategy can be the right option-trading approach for investors who are bullish on the market and expect it to move upwards in the near future.