“Band” indicates a market-neutral option trading strategy, which has profit potential on either side of price changes. The strap originated from a slightly modified version of the straddle. The straddle provides equal profit potential on either side of the underlying price change, making it an effective market-neutral strategy, while the straddle is a “bullish” market-neutral strategy, which is equivalent to an equivalent downward movement. In comparison, it doubles the profit potential it generates when prices rise.
Band options provide unlimited profit potential when prices rise, and limited profit potential when prices fall. The risk/loss is limited to the total amount of option premiums paid plus brokerage commissions.
The cost of building a strap is high because it requires three options:
- Purchase 2 ATM (at parity) call options
- Purchase 1 ATM (at par) put option
All three options should be purchased with the same underlying security, the same strike price and expiry date. The underlying securities can be any optional securities, that is, stocks like IBM or indexes like SP-500.
With payment function
Let’s create a seat belt for stocks currently trading at around $100. Since we are buying ATM options, the strike price of each option should be close to the underlying price, which is $100.
The following is the basic return function for each of the three option positions. The overlapping blue and pink charts represent LONG CALL options with a strike price of $100 (each price is $6.5). The yellow chart represents the LONG PUT option (costing $7). We will consider the price (option premium) in the last step.
Now, let us add these positions to get the net return function (turquoise):
Finally, let us consider the price. The total cost is (6.5 USD + 6.5 USD + 7 USD = 20 USD). Since all are long options, i.e. purchases, the position generates a net debit of $20. Therefore, the net income function (turquoise chart) will move down by $20, giving the brown net income function considering price:
Strap profit and risk scenarios
Band options have two profit areas, that is, the return function remains above the horizontal axis. In this example, when the underlying price is higher than US$110 or lower than US$80, the position will be profitable. These are called break-even points because they are “break-even mark” or “no profit, no loss” points.
- Upper breakeven point = Bullish/bearish strike price + (net premium paid/2)
= $100 + ($20/2) = $110, for this example
- Lower breakeven point = Strike price of the call/put option-the net premium paid
= $100 – $20 = $80, for this example
With profit and risk profile
This transaction has unlimited profit potential above the break-even point because, at least in theory, the price can rise to infinity. For each point acquired by the underlying securities, the transaction will generate two profit points-that is, for every dollar increase in the underlying securities, the income will increase by two dollars.
This is where the bullish outlook of the belt game provides better profits on the upside versus the downside, and the difference between the belt game and the straddle that provides the same profit potential on both sides.
Since the underlying securities cannot fall below $0, the profit potential of this transaction below the break-even point is limited. For each point loss of the underlying security, the transaction will generate a profit point.
Upward Strap Profit = 2 x (underlying price-call option strike price)-net premium paid-brokerage and commission
Assuming that the underlying securities closed at 140 US dollars, then the profit = 2 * (140 US dollars-100 US dollars)-20 US dollars-brokerage business
= 60 USD-Brokerage business
Strap down profit = strike price of the put option-underlying price-net premium paid-brokerage and commission
Assuming that the underlying securities closed at 60 US dollars, then profit = 100 US dollars-60 US dollars-20 US dollars-brokerage business
= $20 – Brokerage business
The risk or loss area is the area where the return function lies below the horizontal axis. In this example, it is located between these two break-even points, and it will suffer a loss when the underlying object remains between $80 and $110. The loss will vary linearly based on the underlying price.
Maximum loss of Strap transaction = Net option fee paid + brokerage commission
In this example, the maximum loss = 20 USD + brokerage business
Band strategy is very suitable for traders seeking to profit from high volatility and potential price changes in either direction. Traders of long-term options should avoid using belts, as they will generate considerable premiums due to time decay. As with all trading strategies, maintain a clear profit target and close the position when the target is reached. Although the maximum loss is limited and a stop loss has been set in the position, traders should also pay attention to the level of stop loss caused by changes in the underlying price and fluctuations.