The strip option strategy is a popular option strategy among options traders. Traders use this strategy when they are bearish on the stock and anticipate higher volatility in the next few days or weeks. This strategy is actually a variation of a long straddle options strategy. However, it involves an extra long put option.
If you want to understand the strip option strategy, then you are on the right platform. Like always, we are going to explain this strategy in the easiest way. So, let’s begin right away.
A strip option strategy is a bearish options strategy. It involves buying one call option and two put options with the same strike price. Traders, with a bearish outlook on a stock, use this strategy when they expect a significant rise in volatility in the near future.
A strip option strategy works on a very simple mechanism. When implementing this strategy, you have to buy three at-the-money options simultaneously. Three options that you buy to implement this strategy include one call option and two put options. So, you are actually buying options in both directions of potential price movement. Although a strip option strategy is a bearish strategy, you are actually covering both the upside and downside.
Now, what are you expecting to achieve with a strip option strategy? You are actually placing bounds around the current market price of the underlying security. As you are covering both the upside and downside, you can gain irrespective of the direction of the price movement. However, you make greater gains when the price moves downward. Moreover, high volatility is the major factor that can make your trade successful when implementing this strategy.
Enabling you to take advantage of price moving in either direction is the beauty of all option trading strategies. Such strategies offer different combinations to enable you to make a significant profit. However, the key is to carefully select these combinations. A strip option strategy is also among these option strategies as we have mentioned earlier. Additionally, traders consider it among the best bearish market-neutral strategies because of two main reasons. Firstly, it offers maximum profit potential. Secondly, it empowers you to make a profit irrespective of the direction of the price movement.
When to use a strip option strategy?
As mentioned earlier, traders use this strategy when they are bearish on the underlying security. However, this isn’t enough. You should use this strategy when you have reasons to believe that high price fluctuations are imminent. It often happens when the market moves at a good speed in either direction. Although it is considered a neutral to negative strategy, you can make significant gains when the price rises. However, a downward price movement suits this strategy as it maximizes your gains.
Risk and reward when using a strip option strategy
A strip option strategy is quite popular because it offers higher profit potential but lower risk. If applied correctly, it offers huge profit when the price of the underlying security dramatically moves in either direction. However, the profit potential doubles when the price plummets.
On the flip side, if the price of the underlying security doesn’t move dramatically and stays within a certain limit, traders incur losses. The net premium paid is the total loss in this case. How so? Because at-the-money call and put options become worthless at the expiration date. Therefore, losses only include the net premium paid on three options.
Now, what about breakeven when using a strip option strategy? There are two breakeven points. The first one is when the price moves above and your strike price plus premium becomes your breakeven. The second one is when the price moves below. You can calculate it by dividing the premium paid by 2 and subtracting it from the strike price.
How to exit a strip option strategy?
A strip option strategy is easy to implement. Similarly, exiting this strategy is also easy. You can simply exit the strategy by selling at-the-money calls and put options. If you want to minimize risk, sell options bought a few days before the expiration date.
Advantages and disadvantages
A strip option strategy is a popular option strategy because it offers certain advantages.
- Easy to implement and execute options trading strategy
- Enables you to capitalize on the dramatic price movement of the underlying security in either direction.
- Comparatively less risky than other option strategies.
- Promises higher profit potential as there is no limit to how much the price of the underlying security can rise.
On the flip side, you have to cope with the following disadvantages when using this strategy.
- Only can use this strategy only in particular circumstances such as events expected to cause high volatility in the future.
- High swings in the price of the underlying security in either direction are a must for this strategy.
- Expensive strategy as compared to other option trading strategies.