Strip Options: A Market Neutral Bearish Strategy

This article will cover "strip options," a market-neutral strategy that can make a profit regardless of the underlying price movement. A "strip" strategy is a modified version of a long-straddle strategy. Straddles offer equal profit potential regardless of underlying price movements (making them a "perfectly" market-neutral strategy). A strategy that provides double the profit potential for a downward price move relative to an equivalent upward price movement. A "strap" is, however, a bullish market-neutral strategy. The strip strategy can make large profits when the underlying stock prices move strongly upwards or downwards at expiration. A downward move will result in greater gains. This position has a limited risk of loss, minus the option premium and brokerage fees.

Strip Construction

Construction of the strip position can be costly as it requires three ATM options.

• Buy 1x ATM Call
• Buy 2x ATM Puts

These options must be purchased on the same underlying with the same strike price and expiry date.

Example

Let's say you want to create a strip option position for a stock that is currently trading at $100. ATM options can be bought, so the strike price should be closest to the underlying price. Let's say $100. These are the basic payoffs for each of these three options. The blue graph represents the $100 strike price long-call option (assuming a $6 cost). The pink and yellow graphs represent the two long-put options that cost $7 each. In the end, we'll consider the price (options premiums). Let's now add all of these options together to get the net payoff function (turquoise):

Let's look at the prices. The total cost of the position will be $6 + $7 + $7 = $20 This position will require a net debit $20 because all options are long (i.e. purchases). The net payoff (turquoise plot) will decrease by $20. This gives rise to the brown-colored net payout function, considering prices.

Profit and Risk Scenarios

There are two profit zones for strip options: the horizontal axis is where the brown payout function does not exceed the horizontal, and the vertical axis is when the reward function exceeds the vertical. According to the illustration provided by the strip option, the position is profitable if the underlying price is either higher than $120 or lower than $90. Because these points represent "profit-loss borders" or places at which there is "no profit, no loss," they are also known as "breakeven points."

Profit and Risk Profile

The trader can make unlimited profits beyond the upper breakeven point, which is a price increase of the underlying. This is because the price can increase to any level, offering an unlimited profit. One profit point is earned for every price movement of the underpinning. This means that a dollar increase in the price of an underlying share will increase the payoff by one dollar.

Below the lower breakeven, i.e., The trader will not make any profit if the underlying price falls below $0, which is the worst-case scenario for bankruptcy. The trader will earn two profit points for each downward price movement of the underpinning. The bearish outlook for strip options offers a better profit margin on the downside than on the upside. This is why the strip is different from a normal straddle, which can offer equal profit potential on both sides.

Additional Considerations

For a trader who expects a significant price change in the underlying stock price but is not certain about its direction but still anticipates a lower price movement, the strip option trading strategy is the best. Although there may be a significant price movement in either direction, it is likely to be in a downward direction. These are real-life scenarios that make strip option trading possible:

• The company is launching a new product.
• The company should not expect too many good or bad earnings.
• Results from a project bidding where the company has submitted a bid.

These cases can lead to product launches that are either successful or unsuccessful, earnings may be too high or low, and bids may be won or lost by the company. All of these could cause large price swings, which one is not sure of the direction.

Conclusion

An implicit stop-loss has been built into the strip position due to the small maximum loss. However, active strip options traders keep other stop-loss levels based on indicative volatility and underlying price movements. Traders must call on the probability of either an upward or downward movement and then choose between strap or strip positions.