Strip Options: A Market Neutral Bearish Strategy

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Strip Options: A Market Neutral Bearish Strategy

Combinations in options trading provide attractive chances in a variety of settings. Whether the underlying stock prices rise, fall, or stay steady, well chosen option combinations provide enough profit potential.

This article discusses “strip options,” a market neutral trading strategy that allows for profit on either side of the underlying’s price movement. A “strip” approach is simply a slightly modified variation of a “long straddle.” Straddles offer equal profit potential on either side of the underlying price movement (making it a “perfect” market neutral strategy), whereas the strip is a “bearish” market neutral strategy that offers double the profit potential on a downward price move compared to an equivalent upward price move (a “strap,” in contrast, is a bullish market-neutral strategy).

When the underlying stock price makes a big move either upwards or downwards at expiry, the strip technique may provide large profits, with a downward move yielding larger profits. This position’s entire risk or loss is restricted to the whole option price paid (plus brokerage fees and commissions).

Key Takeaways

  • A strip is a market-neutral bearish strategy that pays out more when the underlying asset falls than when it rises.
  • A strip is similar to a long straddle but uses two puts and one call instead of one of each.
  • The greatest possible loss on a strip is the option price plus any fees or commissions.

Strip Construction

The cost of creating the strip position may be considerable since it requires the purchase of three at-the-money (ATM) options:

  1. Buy 1x ATM Call
  2. Buy 2x ATM Puts

These options should be purchased with the same underlying, strike price, and expiration date.

Example

Assume you’re setting up a strip option position on a company that’s presently trading at $100. Because ATM options are purchased, the strike price for each option should be the closest possible to the underlying price; for example, $100.

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The fundamental payout functions for each of the three option positions are shown below. The blue graph depicts a long call option with a strike price of $100 (assuming a cost of $6). The two long put options (costing $7 each) are represented by the overlapping yellow and pink graphs. We’ll assess the price (options premiums) in the last phase.

Image by Sabrina Jiang © Investopedia2021

Now, sum together all of these option positions to produce the net payoff function (turquoise color):

Image by Sabrina Jiang © Investopedia2021

Finally, pricing should be considered. The total cost is ($6 + $7 + $7 = $20). Because all of the options are long (i.e., purchases), there is a net negative of $20 for opening this position. As a result, the net payoff function (turquoise plot) will move down by $20, yielding the brown-colored net payoff function with prices considered:

Image by Sabrina Jiang © Investopedia2021

Profit and Risk Scenarios

Strip options have two profit zones, where the brown payout function stays above the horizontal axis. The trade will be profitable in this strip option example if the underlying price rises over $120 or falls below $90. These are the “profit-loss border markers” or “no-profit, no-loss” locations and are referred to as breakeven points.

Image by Sabrina Jiang © Investopedia2021

In general:

  • Upper breakeven point = call/put strike price + net premium paid

= $100 + $20 = $120, for this example

  • Lower breakeven point = call/put strike price – (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 infinite profit potential, since the price may potentially go to any level of profit. The trader will get one profit point for every single price point fluctuation of the underlying (i.e., one dollar increase in underlying share price will increase the payoff by one dollar).

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Below the lower breakeven mark, the trader has little profit possibilities since the underlying price cannot go below $0 on a negative price movement (worst case bankruptcy scenario).However, the trader will get two profit points for every single downward price point movement of the underlying.

This is where a negative view for a strip option varies from a typical straddle, which gives equal profit potential on both sides.

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 closes at $140, the profit is as follows:

= $140 – $100 – $20 – brokerage = $20 ( – brokerage)

Profit in Strip Option in the Downward Direction

If the price falls instead, we would calculate as follows:

2 x (strike price of puts – price of underlying) – net premium paid – brokerage and commission

Assuming the underlying closes at $60, the profit is as follows:

= 2 ($100 – $60) – $20 – Bbokerage = $60 ( – brokerage)

The risk (loss) area is defined as the area where the brown payout function is located below the horizontal axis. In this case, it is between these two breakeven thresholds, implying that this investment will be losing money as long as the underlying price continues between $90 and $120.

Loss amounts will change linearly with respect to the underlying price, where:

Maximum loss in strip option trading= net option premium paid + brokerage and commission

In this example, the maximum loss = $20 + brokerage

Other Considerations

The strip option trading technique is ideal for a trader who anticipates a significant price shift in the underlying stock price, is unsure of the direction, but anticipates a greater possibility of a downward price move. A large price move in either way is possible, but the odds are that it will be in the negative direction.

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The following are real-life circumstances that are appropriate for strip option trading:

  • A company’s introduction of a new product
  • Expecting the firm to announce either too excellent or too negative profits
  • The outcomes of a project bidding process in which the business participated

In some circumstances, a product launch may be a success or a disaster, profits could be too good or too terrible, the firm could win or lose a bid—all of this could contribute to enormous price fluctuations with no clear direction.

The Bottom Line

The strip option strategy is ideal for short-term traders who will gain from the underlying price movement’s strong volatility in either direction. Long-term option traders should avoid this since buying three options for the long term would result in a significant premium going toward time decay value, which erodes over time. As with any other short-term trading technique, it is best to set a specific profit objective and exit the position once that target is met.

Although an implicit stop-loss is built into this strip position (because to the restricted maximum loss), active strip options traders maintain additional stop-loss levels depending on underlying price movement and indicative volatility. The trader must decide if the likelihood is higher or lower and then choose strap or strip positions appropriately.

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