What it means
An option is a contract that gives the holder the right, but not the obligation, to buy or sell an asset at a fixed price on or before a set date. A call gains when the asset price rises and a put gains when it falls.
A strip combines one call with two puts, so the investor is paying for protection against a fall twice over. The structure is a variation of the straddle, which buys one call and one put.
By doubling the puts, the strip makes the position gain twice as fast on the downside as on the upside. Traders use it when they expect a big move, perhaps around a profit announcement or a regulatory decision, and they think a fall is more likely than a rise.
The cost is the total premium paid for all three options. That premium is also the most the investor can lose, which happens if the asset ends exactly at the strike price and all three options expire worthless.
This makes the risk defined, though the cost can be high because the investor is buying three options. To make a profit, the price must move far enough to cover the premium.
On the upside, the asset must rise above the strike by the full premium. On the downside, because two puts are working, it needs to fall below the strike by only half of the premium.
A strip should not be confused with strip bonds or with the strip of a futures contract, which means a series of consecutive contract months. The word has several meanings in finance, so context decides which is intended.
A strap, the mirror image strategy, uses two calls and one put for those with a bullish lean.
In practice
Real-world examples.
Example
A trader expects a pharmaceutical company to announce trial results next month and believes failure is more likely than success. She buys a strip so that a collapse in the price pays double, while a surprise success still produces a gain. Her maximum loss is the premium she paid.
Example
A portfolio manager holds a large position in an energy stock ahead of a regulatory decision. He buys a strip to benefit from a sharp move either way while leaning towards a fall. The premium is treated as an insurance cost in the fund's accounts.
Example
An investment bank's trading desk offers a client a strip on a major index before a central bank meeting. The desk prices the three options together and quotes a single net premium, showing the client the breakeven levels on each side.
Formula
Calculation
Total cost = call premium + (2 x put premium)
Upside breakeven = strike price + total cost
Downside breakeven = strike price - (total cost / 2)
Suppose a stock trades at $50, and an investor buys a strip with a $50 strike. The call premium is $3 and each put premium is $2. Total cost = 3 + (2 x 2) = $7 per share, or $700 for a contract covering 100 shares. Upside breakeven = 50 + 7 = $57. Downside breakeven = 50 - (7 / 2) = $46.50. Check: at $46.50 the two puts are each worth $3.50, giving 2 x 3.50 = $7, which equals the cost.Case study
Seen in the real world.
Linden Capital is an illustrative, fictional trading firm whose analyst expected a mid-sized retailer to report a sharp change in profit but could not tell which way, although the sector was weakening. A straddle seemed too symmetrical, so the team chose a strip with a $40 strike, paying $2.50 for the call and $1.75 for each put.
The total cost was $2.50 + (2 x $1.75) = $6.00 per share. The retailer reported a profit warning and the stock fell to $32. Each put was worth $8, so the two puts paid $16, the call expired worthless, and the net gain was $16 - $6 = $10 per share.
Had the stock instead stayed near $40, the whole $6.00 would have been lost. The illustrative lesson is that a strip works only when the move is large, and the trader accepts a total loss otherwise.
Watch out
Common mistakes.
- Assuming a strip is a safe strategy because the loss is limited, when the whole premium is lost if the price stays near the strike.
- Using a strip when the expected move is small, since the combined premium of three options can exceed the profit.
- Confusing a strip with a strap, which uses two calls and one put and leans towards a price rise.
Questions
People also ask.
What is the difference between a strip and a straddle?
A straddle buys one call and one put, while a strip buys one call and two puts, giving extra exposure to a fall.
When does a strip lose money?
It loses when the price finishes between the two breakeven levels at expiry, with the maximum loss at the strike price.
Does the word strip always mean this options strategy?
No, in other contexts it can mean the separation of a bond into parts or a series of futures contract months.
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