Strip

The Strip strategy is an options trading technique used when an investor expects significant volatility in the underlying asset's price with a stronger bearish bias. It involves purchasing 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. The strip 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 Setup

Imagine an investor who anticipates high volatility with a potential downward shift in a stock currently trading at $50. To capitalize on this expectation, the investor might set up a strip by:

Buying two put options with a strike price of $50, paying a premium of $4 each.
Buying one call option with the same strike price of $50, paying a premium of $4.

This results in a total cost of $12 ($4 for the call + $8 for the puts), which represents the maximum potential loss.

Who Should Consider It

The strip strategy is ideal for traders who are very confident in increased volatility and suspect that the movement could be more pronounced to the downside. It is particularly favored in bearish markets or when negative catalysts are expected to impact the underlying asset.

Strategy Explained

In a strip, the call option offers profits if the stock price rises significantly, 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

The sweet spot for this strategy is when the stock price either significantly exceeds the upper breakeven point or drops well below the lower breakeven point. The more pronounced the move, especially downwards, the higher the potential profit.

Max Profit Potential

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 primary risk involves the stock price ending close to the strike price at expiration, resulting in the loss of the entire premium paid.

Time Decay

Time decay (theta) impacts this strategy negatively. As expiration approaches without a significant move in the stock price, the value of both the puts and the call will decrease. However, this decay occurs faster as the expiration nears, potentially eroding the value of the position unless a significant price move happens early.

Implied Volatility

An increase in implied volatility would generally increase the value of the options in the strip, benefiting the position since it relies on significant price moves. Conversely, a drop in implied volatility would be detrimental, especially if it occurs without accompanying price moves.

Conclusion

A strip is a powerful strategy for capitalizing on expected high volatility with a bearish outlook. It combines the benefits of both puts and calls while favoring downward movements, making it suitable for volatile bear markets or ahead of anticipated negative news or events that might impact the underlying asset significantly.