The feasibility of combinations in options trading allows profitable opportunities in varying scenarios. Be it the underlying stock prices going up, going down, or remaining stable, suitably selected option combinations offer apt profit potential.
This article goes over “strip options,” one of the market neutral trading strategies with profit potential on either side of the underlying’s price movement. A “strip” is essentially a slightly modified version of a long straddle strategy. Straddles provide equal profit potential on either side of underlying price movement (making it a “perfect” market neutral strategy), while the strip is instead a “bearish” market neutral strategy providing double the profit potential on downward price move compared to equivalent upward price move (a “strap,” in contrast, is a bullish market-neutral strategy).
Large profit is attainable with the strip strategy when the underlying stock price makes a strong move either upwards or downwards at expiration, with greater gains to be made with a downward move. The total risk or loss associated with this position is limited to the total option premium paid (plus brokerage fees and commissions).
- A strip is a bearish market-neutral strategy that pays off relatively more when the underlying asset declines than when it rises.
- A strip is essentially a long straddle, but instead utilizes two puts and one call instead of one of each.
- The maximum potential loss on a strip is the price paid for the options plus fees or commissions.
The cost outlay involved in constructing the strip position can be high as it requires three at-the-money (ATM) options purchases:
- Buy 1x ATM Call
- Buy 2x ATM Puts
These options should be bought on the same underlying, with the same strike price and same expiry date.
Assume you are creating a strip option position on a stock currently trading around $100. Since ATM options are bought, the strike price for each option should be nearest available to the underlying price; let’s take as an example $100.
Here are the basic payoff functions for each of the three option positions. The blue graph represents the $100 strike price long call option (assume $6 cost). The overlapping yellow and pink graphs represent the two long put options (costing $7 each). We’ll take the price (options premiums) into consideration at the last step.
Now, let’s add all these option positions together, to get the following net payoff function (turquoise color):
Finally, let’s take prices into consideration. Total cost will be ($6 + $7 + $7 = $20). Since all are long options (i.e., purchases), there is a net debit of $20 for creating this position. Hence, the net payoff function (turquoise plot) will shift down by $20, giving us the brown-colored net payoff function with prices taken into consideration:
Profit and Risk Scenarios
There are two profit areas for strip options i.e. where the brown payoff function remains above the horizontal axis. In this strip option example, the position will be profitable when the underlying price moves above $120 or drops below $90. These points are known as breakeven points as they are the “profit-loss boundary markers” or “no-profit, no-loss” points.
- Upper breakeven point = strike price of call/puts + net premium paid
= $100 + $20 = $120, for this example
- Lower breakeven point = strike price of call/puts – (net premium paid / 2)
= $100 – ($20/2) = $90, for this example
Profit and Risk Profile
Beyond the upper breakeven point (i.e., on an upward price movement of the underlying), the trader has unlimited profit potential, as theoretically the price can move to any level upwards offering unlimited profit. For every single price point movement of the underlying, the trader will get one profit point (i.e., one dollar increase in underlying share price will increase the payoff by one dollar).
Below the lower breakeven point, i.e. on a downward price movement of the underlying, the trader has limited profit potential as the underlying price cannot go below $0 (worst case bankruptcy scenario). However, for every single downward price point movement of the underlying, the trader will get two profit points.
This is where the bearish outlook for strip option offers better profit on the downside compared to the upside, and this is where the strip differs from a usual straddle which offers equal profit potential on either side.
Profit in Strip Option in the Upward Direction
If the underlying moves up, we can compute the following:
Price of underlying – strike price of call – net premium paid – brokerage and commission
Assuming the underlying ends at $140, then profit would be:
= $140 – $100 – $20 – brokerage = $20 ( – brokerage)
Profit in Strip Option in the Downward Direction
And, if the price moves down instead, we would compute as follows:
2 x (strike price of puts – price of underlying) – net premium paid – brokerage and commission
Assuming the underlying ends at $60, then profit would be:
= 2 ($100 – $60) – $20 – Bbokerage = $60 ( – brokerage)
The risk (loss) area is the region where the brown payoff function lies below the horizontal axis. In this example, it lies between these two breakeven points i.e. this position will be loss-making when the underlying price remains between $90 and $120.
Loss amounts will vary linearly depending upon where the underlying price is, where:
Maximum loss in strip option trading = net option premium paid + brokerage and commission
In this example, the maximum loss = $20 + brokerage
The strip option trading strategy is perfect for a trader expecting a considerable price move in the underlying stock price, is uncertain about the direction, but also expects a higher probability of a downward price move. There may be a big price move expected in either direction, but chances are more that it will be in the downward direction.
Real-life scenarios ideal for strip option trading include the following:
- Launch of a new product by a company
- Expecting too good or too bad earnings to be reported by the company
- Results of a project bidding for which the company has placed a bid
In these cases, a product launch may be either a success or a failure, or earnings may be too good or too bad, a bid may be won or else lost by the company—all of these may lead to large price swings where one is uncertain of the direction.
The Bottom Line
The strip option strategy fits well for short term traders who will benefit from the high volatility in the underlying price movement in either direction. Long-term options traders should avoid this, as purchasing three options for the long term will lead to a considerable premium going toward time decay value, which erodes over time. As with any other short term trade strategy, it is advisable to keep a clear profit target and exit the position once the target is achieved.
Although an implicit stop-loss is already built into this strip position (due to the limited maximum loss), active strip options traders do keep other stop-loss levels based on underlying price movement and indicative volatility. The trader needs to take a call on upward or downward probability, and accordingly select strap or strip positions.
View more information: https://www.investopedia.com/articles/active-trading/071614/strip-options-market-neutral-bearish-strategy.asp