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.

The current scenario of equity, commodity and forex markets is very volatile. It’s extremely difficult for investors to speculate the direction where the market is heading. There are many investors on the global platform trading in the futures market. It is considered to be most risky and speculative of all the markets. Let’s go in little depth to understand the term futures market and its function before actually going to the concept of leverage.
Basically, a futures contract is an agreement between two parties that commits one party to sell a security or commodity to the other at a given price and on a specified future date. This makes it possible to transfer the risk from those who want to avoid it (hedgers) to those who are willing to accept it (speculators). Hedgers can be individuals or firms that make purchases and sales in the futures market solely for the purpose of establishing a price level months in advance for something they later intend to buy or sell in the cash market. Their sole purpose is to protect themselves against the risk of an unfavorable price change in the interim.

Example:
An individual enters into a futures contract to sell 100 shares of ABC Ltd. at Rs.1000 each after one month in the futures exchange. This contract protects the price he/she is intending to get for this stock in the period of one month.
With the basic plot of the futures market clear it will be easier to understand the concept of leverage in the futures market and why it is a double-edged sword. The leverage of futures trading results from the fact that only a relatively small amount of money (known as initial margin) is required to buy or sell a futures contract. For example, a deposit of only Rs.100,000 might enable an investor to buy a futures contract representing Rs.1,500,000 worth of a particular stock/commodity. The initial margin is typically 5 to 15 percent of the value of the underlying contract, although in some cases it is even more or less. The smaller the margin in relationship to the value of the futures contract, the greater will be the leverage and risk.

High leverage can produce large profits when compared to the initial margin if the speculator correctly anticipates the future price change. Alternatively, if prices move in the opposite direction from what was anticipated, the result would be large losses. Thus, the double-edged sword.

Another Example:
An investor anticipates rising stock prices and buys one December Nifty index futures contract (lot size: 100) at a time when the S&P Nifty is trading at 2800. The initial margin required is Rs.28000 (assuming 10% margin cost). The value of the Nifty futures contract is calculated by multiplying the current level of the S&P Nifty by 100 (the lot size) i.e. the contract value is Rs.280,000 (100 x 2800); each point change in the index represents Rs.100 gain or loss.
Therefore, an increase in the index from 2800 to 2850 would increase the investment (50 x Rs.100 per point) Rs.285,000 i.e. a profit of Rs.5,000. A decrease of S&P Nifty from 2800 to 2400 during a contract period in this volatile markets would wipe out the investment to (400 x Rs.100 per point) Rs.240,000 i.e. a loss of Rs.40,000.
Although, a futures contract provides exactly the same actual profit as owning or selling short the actual securities or commodities represented by the contract, the low initial margin magnifies the percentage profit or loss potential. So, it can be concluded that in this market, speculators must be prepared for the possibility of losing their investment in a single day. An investor who is not reconciled to that possibility should avoid this market altogether.