The viability of combinations in options trading allows profitable opportunities in varying scenarios. Be it the underlying stock prices going up, affluent down, or remaining stable, suitably selected option combinations offer apt profit potential.
This article assent ti over “strip options”, one of the market neutral trading strategies with profit potential on either side of the underlying’s penalty movement. A “strip” is essentially a slightly modified version of a long straddle strategy. Straddles provide equal profit the right stuff on either side of underlying price movement (making it a “perfect” market neutral strategy), while the strip is as an alternative a “bearish” market neutral strategy providing double the profit potential on downward price move compared to comparable upward price move (a “strap”, in contrast, is a bullish market-neutral strategy).
Large profit is attainable with the rob strategy when the underlying stock price makes a strong move either upwards or downwards at expiration, with prominent gains to be made with a downward move. The total risk or loss associated with this position is predetermined to the total option premium paid (plus brokerage fees & commissions).
- A strip is a bearish market-neutral blueprint that pays off relatively more when the underlying asset declines than when it rises.
- A strip is essentially a big straddle, but instead utilizes two puts and one call instead of one of each.
- The maximum potential loss on a strip is the price turn out to bed for the options plus fees or commissions.
The cost outlay involved in constructing the strip position can be turbulent as it requires three at-the-money (ATM) options purchases:
- Buy 1x ATM Call
- Buy 2x ATM Puts
All 3 options should be bought on the same underlying, with the after all is said strike price and same expiry date.
Payoff function with an example:
Assume you are creating a strip recourse position on a stock currently trading around $100. Since ATM options are bought, the strike price for each selection should be nearest available to the underlying price; let’s take as an example $100.
Here are the basic payoff functions for each of the three selection positions. The Blue graph represents the $100 strike price long call option (assume $6 expenditure). The overlapping Yellow and Pink graphs represent the two long put options (costing $7 each). We’ll take the price (alternatives 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):
For ever, 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 producing this position. Hence, the net payoff function (turquoise plot) will shift down by $20, giving us the brown colored net payoff rle of with prices taken into consideration:
Profit & Risk Scenarios
There are two profit areas for strip alternatives i.e. where the brown payoff function remains above the horizontal axis. In this strip option example, the settle will be profitable when the underlying price moves above $120 or drops below $90. These views are known as breakeven points as they are the “profit-loss boundary markers” or “no-profit, no-loss” points.
- Upper Breakeven Nicety = Strike Price of Call/Puts + Net Premium Paid
= $100 + $20 = $120, for this example
- Lower Breakeven Point = Strike Value of Call/Puts – (Net Premium Paid/2)
= $100 – ($20/2) = $90, for this example
Profit and Risk Profile
Beyond the upper breakeven train a designate i.e. on an upward price movement of the underlying, the trader has unlimited profit potential, as theoretically the price can move to any level upwards donation unlimited profit. For every single price point movement of the underlying, the trader will get one profit point – i.e. one dollar extend in underlying share price will increase the payoff by one dollar.
Below the lower breakeven point, i.e. on a downward prize movement of the underlying, the trader has limited profit potential as the underlying price cannot go below $0 (worst prove bankruptcy scenario). However, for every single downward price point movement of the underlying, the trader will get two profit ideas.
This is where the bearish outlook for strip option offers better profit on the downside compared to the upside, and this is where the clothing differs from a usual straddle which offers equal profit potential on either side.
Profit in Unclothe Option in the Upward Direction
If the underlying moves up, we can compute: Price of Underlying – Strike Price of Call-Net Premium Deal out – Brokerage & Commission
Assuming underlying ends at $140, then profit
= $140 – $100 – $20 – Brokerage = $20 ( – Brokerage)
Profit in Undress Option in the Downward Direction
And, if the price moves down instead, we would compute: 2 x (Strike Price of Recommend b suggests – Price of Underlying) – Net Premium Paid – Brokerage & Commission
Assuming the underlying ends at $60, then profit
= 2($100 – $60) – $20 – Brokerage = $60 ( – Brokerage)
The hazard (loss) area is the region where the brown payoff function lies below the horizontal axis. In this norm, it lies between these two breakeven points i.e. this position will be loss-making when the underlying price ends b bodies between $90 and $120.
Loss amounts will vary linearly depending upon where the underlying price is, where: Apex Loss in Strip Option Trading = Net Option premium paid + Brokerage & Commission
In this example, the maximum harm = $20 + Brokerage
The strip option trading strategy is perfect for a trader expecting considerable appraisal move in the underlying stock price, is uncertain about the direction, but also expects a higher probability of a downward worth move. There may be a big price move expected in either direction, but chances are more that it will be in the downward road.
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 boomed by the company
- Results of a project bidding for which the company has placed a bid
In these cases, a product launch may be either a good or failure, or earnings may be too good or too bad, a bid may be won or else lost by the company – all of these may lead to large price swings where one is unfixed of the direction.
The Bottom Line
The strip option strategy fits well for short term traders who will aid from the high volatility in the underlying price movement in either direction. Long term options traders should elude this, as purchasing three options for the long term will lead to a considerable premium going towards all at once decay value, which erodes over time. As with any other short term trade strategy, it is intelligent to keep a clear profit target and exit the position once the target is achieved.
Although an implicit stop-loss is already built-in this stripe position (due to the limited maximum loss), active strip options traders do keep other stop-loss levels secured on underlying price movement and indicative volatility. The trader needs to take a call on upward or downward probability, and financial statement select strap or strip positions.