Strap Strangle is a simple options trading strategy used by beginners. This is a strategy used in volatile market conditions.
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About Strap Strangle
Traditionally, strangles options tend to be a neutral options strategy. This makes it suitable for a trader with little idea about the direction of the movement in the price of a security. However, it is possible for an investor to have a bias for one particular direction.
In a situation such as this, a modified version of the strangle strategy can direct gains to the investor.
So, rather than using a simple and equal ratio while buying calls and puts, the investor uses a specific combination which rests on their assumption that the price of the underlying security may move by a sharp margin in an expected direction.
The greatest weakness of the strap strangle strategy lies in the net debit spread. Owing to the up front cost involved in taking positions in this strategy, it can be overwhelming for an investor.
Often, failure of the strategy results in a net loss on expiry of the options which can be daunting on the motivation of the investor.
Due to the nature of the strategy, it can be used by beginners to make profits. There are basically two transactions involved in the strategy, which includes buying calls and put options.
It is ideal to have knowledge of the long strangle strategy to understand the operation of the strap strangle.
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What is the right time to use a Strap Strangle strategy?
An investor can make use of this strategy when they have a volatile outlook on the market sentiment.
However, the element of a bullish upswing in the market is the point of difference between a long strangle and a strap strangle.
So, this strategy is applied by an investor when they have faith that the price of an underlying security will move up, rather than going down.
The scope of making a profit still exists if the price of the security falls down. But it exists more prominently if the price moves up.
Why a beginner is also capable to employ this strategy is because of the two legs of transactions involved. So, since they only need to buy calls and puts in a unique ratio, it is easy for them to implement.
It is notable that there is no strict ratio or formula which can define the number of calls and puts which the investor must opt for. Ideally, a ratio of 2:1 is rewarding for investors but it is open to tuning from them.
It is advisable for investors to choose out of the money options when trading in this strategy. The closer the strike price is to the current trading price of the security, the better it is likely to yield a desirable return.
What is the potential to earn a profit or incur a loss?
The maximum profit from the exercise of this strategy has no limit. However, the maximum loss is restricted and amounts to the amount of net debit spread which forms at the planning stage of the strategy.
Let us understand the possibility of making a profit or incurring a loss under this strategy.
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Planning a Strap Strangle strategy to make a profit
Let us assume that the price of security is INR 50. As an investor, you expect that the price of the security will move by a significant margin in the days to come. Moreover, you have a bullish inclination towards the price movement, owing to market conditions.
Now, you plan to implement the strap strangle strategy and make a profit from it. To do this, you take the following positions:
- You purchase out of the money call options for a strike price of INR 51. These are currently trading at INR 1.5 each so, you buy 2 contracts with 100 options each. The total value of this leg amounts to INR 300.
- You purchase out of the money put options for a strike price of INR 49. These are currently trading at INR 1.5 each so you buy 1 contract with 100 options each. The total value of this leg amounts to INR 150.
As a result of these transactions, you have created a net outflow of INR 450 to implement the strategy.
Now, at the date of expiry of the options, the following situations can occur:
- The stock price of the security may remain at INR 50. In this situation, the options in contracts 1 and 2 above will expire and become worthless. Thus, you will lose out on the entire amount of INR 450 which was the debit spread to purchase the options.
- The stock could trade up at, let’s say, INR 58. The calls in option 1 above will be worth INR 7. So a total amount of INR 1400 will accrue to you. The options in contract 2 above will expire and become worthless. After deducting the amount of net debit spread, you will be left with a net profit of INR 950.
- The price of the security could go down to, let’s say, INR 42. In this case, the options in contract 1 above will expire and become worthless. However, the options in contract 2 above will amount to INR 7 each. So, a total value of INR 700 will accrue to you and after deducting the amount of net debit spread, you will be left with a profit of INR 250.
There is also a possibility to make a loss if the price movement does not occur by enough margin. This could happen in the following cases:
- Let’s say that the stock price is trading at INR 52 on the day of expiry. Then the options in contract 1 above will be worth INR 1 each, for a total value of INR 200. The options in contract 2 above will expire. Out of the INR 450 spent on the debit spread, a recovery of only INR 200 could be made. Hence, net loss will amount to INR 250.
- Let’s say that on the date of expiry, the trading price of the security is INR 48. Then, the calls in contract 1 above will expire and the options in contract 2 above will amount to INR 1 each. The total value of the contract will be worth INR 100. Out of the INR 450 spent on debit spread above, recovery of INR 100 will still amount to a loss of INR 350.
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To Conclude Strap Strangle Strategy
The above example clarifies the situations under which a profit accrues to the investor. At the same time, it also depicts how a loss can materialise under this strategy.
So, in comparison to the long strangle strategy, the strap strangle is certainly more complex. However, in comparison to several other strategies, it is still quite simple and straightforward. This is why even beginners can try their hand at this strategy.
Understanding a strap strangle is relatively easy and as long as the investor has an estimate about the direction of the movement of the stock price, it can be quite rewarding as well.
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