What Is a Strip?
The strip is the process of removing coupons from a bond and then selling the separate parts as a zero coupon bond and an interest paying coupon bond. In the context of bonds, stripping is typically done by a brokerage or other financial institution.
In options, a strip is a strategy created by being long in one call position and two put options, all with the exact same strike price.
A strip is also referred to as a stripped bond or z-bond.
The term "strip" is used to both describe actions taken in the bond market as well as the options market. In the bond market, coupon bonds are literally stripped of their coupons and principle and sold as z-bonds and interest-bearing debt. In the options market, a strip is an investor strategy that takes the opposite position of a variant.
Strip in the Bond Market
STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities. When a strip occurs in the bond market, a Treasury bond or note is stripped by the commercial book-entry system, effectively making it so the bond or note's interest payment and principal payment become separate entities. These new separate investment products are known as a strip bond or a zero coupon bond.
For example, if there is a Treasury note with 10 years to maturity and with semi-annual interest payments, that note can be stripped through the STRIPS process to produce 21 separate debt securities. Since the bond is set to mature in 10 years, the semi-annual interest payments represent 10 x 2 = 20 payment periods. On the last payment period, the principal investment is also repaid, hence, the reason the STRIP can create 21 unique debt instruments. The 20 interest payments become individual strip bonds and the single principle repayment becomes its own bond.
The minimum amount of money needed to purchase a stripped fixed-principle note or Treasury security is $100. Any par amount above $100 has to be stripped in denominations of $100. These types of stripped bonds are very attractive for investors looking to save for retirement or receive a fixed payment in the future. The risk of owning these types of investment vehicles is extremely low.
Strip as an Options Strategy
An investor conducts a strip strategy by purchasing two put options and one call option on a single underlying stock. All three of the options will have the same expiration date and the same exercise price. An investor will take out a strip position on a stock when the investor believes that the underlying price of the stock will plummet in a short time-frame. If the investor is correct and the price drastically decreases, the puts will pay out substantially. If, however, the investor is wrong and the price of the underlying asset increases, the call option will mitigate the loss.