With events in Europe and China shaping the bigger picture on
Wall Street, it is easy to forget that we are smack in the middle
of corporate earnings season. While we are about halfway through
the current earnings calendar, there are several heavy hitters
still scheduled to report. This week alone, we have Hewlett-Packard
Co. (
HPQ
), Wal-Mart Stores Inc. (
WMT
), Deere & Co. (
DE
), and Dell Inc. (
DELL
), just to name a few. As such, options traders still have plenty
of opportunities to benefit from this period of elevated
volatility.
Now, many intermediate options traders have heard of strategies
like straddles and strangles, and these plays work well during of
periods of increased volatility by allowing the investor to profit
regardless of the stock's directional move. The catch is that the
stock has to move big, which is kind of the idea during periods of
elevated volatility. But, what if you have a directional bias on
the underlying stock?
Straddles and strangles may not have an opinion on which
direction the shares of XYZ BrickLayers Corp. will move
post-earnings, but you have your suspicions that the stock is due
for a rally. Luckily for you, there is a way to increase your
payout on a rally in XYZ shares, while still maintaining a "hedge"
against a downside move: the strap.
Constructing a Strap
Straps are quite similar in construction to straddles. Instead
of purchasing one at-the-money put and one at-the-money call, the
strap trader will purchase one at-the-money put and
two
at-the-money calls. This gives the position a bias toward a rally
in the underlying shares.
Let's take a look at an example. Sticking with your bullish bias
on XYZ BrickLayers, you expect the company to report blowout
quarterly results after the close on Friday. However, the market
being what it is lately, not to mention the unpredictable nature of
earnings reactions, you feel that you need some downside exposure.
With XYZ trading at $52 per share, you purchase one June 52 put,
last asked at $1.57, and two June 52 calls, last asked at $1.10 (or
$2.20 total). As a result, you enter the trade with a net debit of
$3.77, which represents the most you can possibly lose on the
position.
Potential Outcomes
There are a couple potential outcomes for this strap position.
Under the best-case scenario, XYZ impresses Wall Street with its
quarterly report, and rallies significantly beyond $55.27 per share
(the upper breakeven level). Keep in mind that a rally in the
underlying stock is preferred because you have bought two calls for
every one put. Assuming that XYZ closes at $60 per share at June
expiration, the purchased June 52 put would expire worthless, while
the two purchased June 52 calls would be worth a combined $16.
Subtracting the net debit of $3.77 paid at initiation, your profit
comes in at $12.23.
Your next best outcome for this strap strategy is for XYZ to
plunge below $48.23 per share (the lower breakeven level). Assuming
that XYZ sorely disappoints investors with its quarterly figures,
and the shares plunge to $45 per share, the purchased June 52 calls
would expire worthless, while the June 52 put would be worth $7.
Subtracting the net debit of $3.77 paid at initiation, your profit
comes in at $3.23.
The only way to lose in this example is for XYZ shares to have
practically no reaction to their earnings data, leaving the shares
close essentially flat at expiration. However, even in a worst-case
scenario where XYZ closes at $52 per share when June options
expire, your losses are limited to the net debit of $3.77 paid at
initiation.
Wrapping Up
It may seem like the strap is the answer to the aggressive
bullish trader's prayers, but options strategies that revolve
around high levels of volatility are rarely as cut and dried as
they seem. Just remember that while high levels of volatility are
beneficial to a strap position, they can also increase the cost of
entering the trade. Furthermore, trading around events, such as
earnings reports and trial results, can be extremely risky. So,
while the strap can give bullish traders a way of participating in
volatile price swings, there is still a palpable degree of risk
involved.
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