A Strip Strangle is a volatile options trading strategy which is suitable for application when a major move in the market is on the cards.
The strategy can benefit the investor no matter which direction the price moves in. Like most strangle strategies, it is a neutral trading strategy.
About Strip Strangle
Due to the weighted nature of the strategy, the investor will need to purchase calls and puts in a specific ratio.
This specific aspect of the strategy takes a departure from the regular option to purchase an equal number of calls and puts.
To plan and implement the strategy, the investor must purchase out of the money calls and out of the money puts in a larger ratio.
It is rare for an investor to go beyond the conventional ratio of 2:1. This ensures that the cost of the options purchased by the investor remains at a bare minimum.
Often, investors associate the act of buying an additional contract with the risk of running losses. This is because the cost of purchasing the additional contract adds to the overall cost of the strategy.
This means that the strategy will have to move by just as much margin in order to obtain a profit level.
Thus, it will be right to say that this volatile strategy is suitable for beginners. The up front debit spread that it creates requires a low level of trading to implement the strategy.
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What is the right time to use the strip strangle strategy?
A bearish inclination to the movement of a stock price gives merit to the use of a strip strangle strategy.
So, after implementing the strategy, if the price of a stock was to go down by enough margin, the investor can benefit from a large quantum of profits.
Although there is significant potential to make a profit even when the price of the security goes up, it is in the best interest of the investor if it goes down instead.
The idea behind the strip strangle is to pick and plan the strategy at a time when the investor expects a fall in the price of the security.
Since, there are only two transactions involved, it is not cumbersome for a new investor to exercise the strategy.
The only strict decision making involved in this strategy is the strike price at which the investor purchases the call and put options.
Plus, the ratio in which the options are taken is also a vital factor which will determine the success of the strategy.
The farther out the strike price happens to be from the actual price of the security, the more will be the margin that the price needs to move across on the date of expiry.
It is a good idea to pick an equal distance between the strike prices of the call and put options.
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|Long Strangle||Reverse Iron Butterfly Spread||Short Butterfly Spread|
|Long Gut||Reverse Iron Condor Spread||Short Condor Spread|
What is the potential to earn a profit or incur a loss on a Strip Strangle strategy?
As long as the price of a stock moves in a particular direction, the possibility to earn a profit is unlimited. The quantum of the profit will be larger if the movement of the price is on a downward trajectory.
On the same hand, the risk to incur a loss has a limit on it. In fact, the maximum amount of loss that an investor can incur is not more than the amount of net debit spread.
As compared to a regular strangle strategy, the profit potential in this strategy is quite high. Plus, as compared to a strip straddle strategy, the net debit spread is also low.
However, the investor needs to pump a higher than usual cash to exercise this strategy. Due to this, the quantum of loss, though limited, can be quite high.
How to implement the Strip Strangle strategy?
The implementation of the strategy is easily understood with the help of an example.
Let us take an example of a stock which is trading at INR 50. The investor expects that the price of the security will move by a significant margin in the days to come. More so, a downward movement in the price cannot be ruled out.
The investor takes the following positions to enter the strategy:
- Buy out of the money calls for a strike price of INR 51. These calls are trading at INR 1.5 each. So, the investor purchases one contract of 100 options each for a total cost of INR 150.
- Buy out of the money puts for a strike price of INR 49. These calls are trading at INR 1.5 each. So, the investor purchases two contracts of 100 options each for a total cost of INR 300.
As a result of these contracts, a net debit spread of INR 450 has formed.
Now, on the date of expiry, the following occurrences can take place:
- The price of the security can stay at INR 50. The options in contracts 1 and 2 above will expire and become worthless. Thus, the initial investment of INR 450 will go waste.
- The price of the security could trade at INR 52. The calls in contract 1 above will be worth INR 1 each. Options in contract 2 above will expire. The recovery of INR 100 will offset the loss and leave a total loss of INR 350.
- The price of the security could trade at INR 56. Calls in contract 1 above will be worth INR 5 each. The options in contract 2 above will expire and become worthless. The total recovery will be worth INR 500 and offset the amount of net loss to leave a profit of INR 50.
- Price of the security could trade at INR 48. The calls in contract 1 above will expire and become worthless. The options in contract 2 above will be worth INR 1 each. Total recovery will be for an amount of INR 200. The final loss will be INR 250.
- The price of the security could trade at INR 44. Calls in contract 1 above will expire and become worthless. The options in contract 2 above will be worth INR 5 each. The total recovery will be INR 1000 and offset the amount of net debit. The final profit remaining for the investor will be INR 550.
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To Conclude Strip Strangle Strategy
Given the design of the strategy, it is not hard to see why it is suitable for a beginner. As such, there is no major planning involved, except to decide the strike prices of the options.
The investor needs to only use their estimate and assumption about the movement of the stock price to enter this strategy.
They can take a position in the strategy if they expect the price of the security to fall down by a significant margin.
Since the strategy makes use of only two transactions, there is no major outlay involved in terms of commission.
The fact that the amount of maximum loss is under restriction also makes this strategy quite attractive for the investors.
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