When to use: Strip Option Strategy is used when the investor is bearish on the stock and expects volatility in the near future.
How it works: Strip option strategy use three option contracts of the same underlying stock, with the same expiry date and same strike prices. In this strategy, you buy 2 at-the-money put options and 1 at-the-money call option.
For example: On 6th September 2013, when the share of HDFC was trading at Rs. 760.00, you decided to buy 2 at-the-money put options at a premium of Rs. 14.95 expiring 26th September 2013; and you bought 1 at-the-money call option at a premium of Rs. 71.90, with a Strike Price of Rs. 760.00 expiring 26th September 2013.
Risk/Reward: In strip option strategy, the risk is limited to the net premium paid for the position and the maximum reward/profit is unlimited. In this strategy you can make huge profits if the underlying stock makes a strong move either on the upside or downside on expiry (however, larger gains will be made with a downward movement).
For 1 ATM Call Option: If the price of HDFC rises above Rs. 760.00 (i.e. the strike price), you can exercise your long call option, but the price of the stock must rise above Rs. 831.90 (i.e. the strike price + the amount of premium) for you to exercise your option and make a profit.
For 2 ATM Put Options: If the price of the share falls below Rs. 760.00 (i.e. the strike price of the long put options), you can exercise your option, but the price of the stock must fall below Rs. 730.10 (i.e. the strike price minus the premiums), for you to exercise your option and make a profit.
The table below shows the net payoff of a strip option strategy assuming different spot prices on the expiry date:
The table above allows you to easily see the break-even points, maximum profit and the loss potential at expiry in rupee terms. The calculations are presented below.
The two break-even points occur when the price of the underlying share equals Rs. 709.10 and Rs. 861.80.
First Break-even Point = Strike price – (net premium paid/2) = Rs. 709.10 (760.00 – (101.80/2))
Second Break-even Point = Strike price + net premium paid = Rs. 861.80 (760.00 + 101.80)
The profit potential is unlimited but higher gain will be made if the share price moves downward.
The maximum loss which the investor may suffer is equal to the net premium paid i.e. 101.80. Maximum loss, in this example, will be incurred if the share price remains equal the strike price (i.e. Rs. 760.00).
How to use the Strip Option Strategy Excel calculator
Just enter your expected spot price on expiry, option strike price and the amount of premium, to estimate your net pay-off from the Strip Option Strategy.
Note: The example and calculations are based assuming a single share though in reality options are based on lots of many shares. For example HDFC’s option contract is for 250 shares. Accordingly the net premium paid will be Rs. 25,450 for 3 lots (i.e. 101.80*250) in our example.