A strap straddle is a strategy geared toward an expectation of volatility, with a slightly bullish bias.
Whereas a straightforward straddle consists of a purchase of one at-the-money call and one at-the-money put, the strap straddle is a ratio trade that requires the purchase of an additional call option, making for a 2-to-1 balance in line with an expectation that the coming volatility is more likely to be bullish.
The strategy has an unlimited profit/limited risk profile, but requires a sharp move in order to cover the costs of the initial purchase – and especially sharp if the move is to the downside.
We’ll have a look at specific break-even points in just a moment, but first let’s examine a case study to better appreciate the ins and outs of the strategy.
This is a chart of 3M (NYSE: MMM) for a little over half a year:
3M was locked in a range for nearly four months, vacillating tightly around the $144 mark for nearly the entire period. By the time September hit, your research indicated it was time for a breakout. A few new acquisitions meant the market would likely react strongly to 3M stock, moving it sharply one way or another – and you suspected it would be higher.
On Sept. 9, you decide to act by buying a strap straddle, a strategy that lets you cash in from any sharp move in the stock, but gives you an extra kicker if you’re right about the move higher.
With the stock at $144, you purchase two at-the-money November 144 calls for $3 each and one November 144 put for $3. Your debit on the trade is exactly $9
Break-Evens, Profits and Losses
To make money on the trade, the stock has to move lower by at least that same $9 and settle below $135. Anything less than that on the downside will produce a loss on the trade.
On the upside, the calculus is slightly different because of the extra call. To break even in that direction, the underlying has to move only half the distance, or $4.50, and settle at or above $148.50 in order to turn a profit.
As it turns out, the stock swings like a drunkard from a chandelier, moving briefly as low as $130 in mid-October, before catapulting north to finally settle at $160 on expiration.
Palpitations!
Your emotions run the full gamut for better than a month, with joy as the stock plummets below $135, despair as it pops back above that number just a week later, and then renewed happiness as the stock pushed toward $150 and beyond.
In the final tally, you earn $700 ([$160 – $144 – $9] x 100), a very good take considering the risks taken at the outset.
Note: The greatest danger to the strap straddle strategy comes from a slow-moving market. A very large move is required just to break even. Maximum loss for the trade is limited to the initial premium expended, and occurs if the trade expires directly on the strike price of the straddle.
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