Strip
The strip strategy is an options trading technique that is applied when an investor expects high volatility in the price of the underlying asset with a stronger bearish bias. The strategy involves buying more put options than call options on the same underlying asset with the same expiration date and strike price. Typically, the ratio is two puts for every one call. This is a variation of the more symmetric straddle, which is used when the direction of the move is uncertain but significant volatility is expected.
The Strip Setup
Consider an investor who expects high volatility with a possible downward shift in a stock trading at $50. To take advantage of this expectation, the investor may set up a strip by:
- Buying two put options at a strike price of $50, paying for them a premium of $4 each.
- Buying one call option at the same strike price of $50, which costs it a premium of $4.
A total cost to a maximum loss is made here, $12, ($4 paid for the call + $8 paid for the puts).
This strip strategy is best suited for those traders who feel very bullish about an increased volatility and have suspicion that the movement may be more pronounced to the downside. This strategy is mostly favored in bearish markets or at times when negative catalysts are expected to affect the underlying asset.
Strategy Explained
In a strip, the call option provides profits if the stock price moves significantly upward, while the double puts provide strong gains if the price falls substantially. The asymmetry favors downward moves, which is why the strategy includes more puts than calls.
Breakeven Process
There are two breakeven points for the strip:
- Upper Breakeven: Calculated by adding the total premium spent to the strike price of the call.
- Lower Breakeven: Calculated by subtracting the total premium from the strike price of the puts, adjusted for the asymmetry in the number of options.
Using the given premiums and strike, the upper breakeven would be $62 ($50 strike + $12 total premium), and the lower breakeven would be $38 ($50 strike - $12 total premium).
Sweet Spot
This strategy hits its sweet spot when the stock price goes far beyond the upper breakeven point or when it plummets to way below the lower breakeven point. The stronger the move, particularly a downward move, the higher the potential profit.
Profit Potential: Maximum
The maximum profit on the downside is theoretically unlimited until the stock reaches zero, while on the upside, the profit is also significant but capped by the fact that there are fewer calls than puts.
Max Loss
The maximum loss is limited to the total premium paid if the stock price at expiration is exactly at the strike price of the options, as all options would expire worthless.
Risk
The major risk is that the stock price may end near the strike price at expiration, which means that all premium paid would be lost.
Time Decay
Time decay (theta) affects this strategy negatively. At expiration, with little stock price movement, the value of both puts and call will decrease. However, this decays faster as time runs closer to expiry which can be detrimental to the value of the position unless a huge price move happens early .
Implied Volatility
This would mean an increase in implied volatility and generally would be favorable for the value of options in the strip since it depends on big price moves. Conversely, a decline in implied volatility would be harmful, especially when this decline happens without accompanying price moves.
Conclusion
A strip is a strong strategy for playing off of anticipated high volatility with a bearish bias. It combines the benefits of both puts and calls but favors downward movements, making it suitable for volatile bear markets or ahead of anticipated negative news or events that may impact the underlying asset significantly.