The feasibility of combinations in option 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. (Want to know more about what "market neutral" means? See "Getting Results with Market-Neutral Funds.")
This article introduces “Strip Options”, one of the market neutral trading strategies with profit potential on either side price movement. “Strip” originates as a slightly modified version of straddle. Straddle provides equal profit potential on either side of underlying price movement (making it a “perfect” market neutral strategy), while the Strip is a “bearish” market neutral strategy providing double the profit potential on downward price move compared to equivalent upward price move. (Learn about its counterpart: "Strap Options: A Market Neutral Bullish Strategy.")
Strip Options offer unlimited profit potential on the upward price movement of the underlying, and limited profit potential on downward price movement. The risk/loss is limited to the total option premium paid (plus brokerage & commission).
Cost of constructing the strip option position is high as it requires 3 options purchases:
- Buy 1 No. * ATM Call
- Buy 2 Nos. * ATM Put
All the 3 options should be bought on the same underlying, with the same strike price and same expiry date.
Payoff function with an example:
Assume you are creating a strip option position on a stock currently trading around $100. Since ATM (At-The-Money) options are bought, the strike price for each option should be nearest available to the underlying price, i.e. $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 price (option 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 graph) will shift down by $20, giving us the Brown colored net payoff function with prices taken into consideration:
Profit & 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 of Strip Option:
Beyond the upper breakeven point i.e. on 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 downward price movement of the underlying, the trader has LIMITED profit potential as 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 downside compared to 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 upward direction = Price of Underlying - Strike Price of Call - Net Premium Paid – Brokerage & Commission
Assuming underlying ends at $140, then profit = $140 - $100 - $20 – Brokerage
= $20 - Brokerage
Profit in Strip Option in downward direction = 2 x (Strike Price of Puts - Price of Underlying) - Net Premium Paid – Brokerage & Commission
Assuming the underlying ends at $60, then profit = 2 *($100 - $60) - $20 – Brokerage
= $60 – Brokerage
The Risk or 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 amount will vary linearly depending upon where the underlying price is.
Maximum Loss in Strip Option Trading = Net Option premium paid + Brokerage & Commission
In this example, maximum loss = $20 + Brokerage
Things to Consider:
The Strip Option Trading Strategy is perfect for a trader expecting considerable price move in the underlying stock price, is uncertain about the direction, but also expects 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
- 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
Product launch may be success/failure, earnings may be too good/too bad, bid may be won /lost by the company – all may lead to big price swings uncertain of the direction.
The Botttom 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 option traders should avoid this, as purchasing three options for the long term will lead to a considerable premium going towards 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 target is achieved. Although the stop-loss is already built-in 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.