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Strip

 

Description

 

The Strip is a simple adjustment to the Straddle to make it more biased toward the downside. In buying a second put, the strategy retains its preference for high volatility but now with a more bearish slant.

 

As with the Straddle, we choose the at-the-money strike for both legs, which means the strategy is expensive. We are therefore requiring a pretty big move, preferably with the stock plunging downwards. As such, our risk is greater than with the Straddle, and our reward is still uncapped. Because we bought double the number of puts, our position improves at double the speed, so the break even to the downside is slightly tighter. The break even to the upside is the strike plus the net debit, which is more than the Straddle because we’ve bought double the amount of puts.

 

Again the same challenges apply regarding Bid/Ask Spreads and the psychology of the actual trade. Remember that time decay hurts long options positions because options are like wasting assets. The closer we get to expiration, the less time value there is in the option. Time decay accelerates exponentially during the last month before expiration, so we don’t want to hold onto OTM or ATM options into the last month.

 

Use the Straddle rules but buy twice as many puts as calls in order to make an adjustment for the Strip.

    

Again, it is important to follow the entry and exit rules (as for straddles), and psychologically speaking, this is another tough strategy to play after you are in. It is very easy to find reasons to exit, even though it is in breach of your trading plan. But you must remember that you got in for a certain reason (or reasons), and you must stay in until one of your other reasons compels you to exit.

 

Here is a reminder of the rules for trading straddles that you must also apply to

strips:

 

1. Choose your preferred stock price range. Some traders choose stocks between  $20.00 and $60.00, but that is a personal preference.

 

2. Only do a Strip on a stock that is close to making an announcement that may  cause a surprise jump in the stock price either way, such as the week before an earnings report.

 

3. Buy at-the-money calls and puts with the expiration at least two months away, preferably three. You can get away with four months if nothing else is available.

 

4. The cost of the Straddle should be less than half of the stock’s recent high less  its recent low. By recent, we mean the last 40 trading days for a two-month   Straddle, the last 60 trading days for a three-month Straddle, or the last 80 days  for a four-month Straddle. The point here is that the cost of the Straddle should  be low in comparison with the potential of the stock to move. If this works

  with the Straddle, then the Strip can be acceptable.

 

5. Exit within two weeks after the news event occurs. Never hold into the final month before expiration. During the final month, your options will suffer increasing time decay, which we don’t want to be exposed to.

 

6. Try to find a stock that is forming a consolidation pattern, such as a flag or pennant, or in other words, where the stock price action has become tighter  and where volatility has shrunk in advance of a big move in either direction.

 

  Typically we are looking for a pennant within the context of a downward trend.   

 

Market Opinion

 

Bearish.

 

P/L

 

 

 

 

 

 

 

 

 

 

When To Use

 

Use this strategy in a bearish environment for a capital gain. Use when volatility is low but you expect increased volatility in either direction.

 

Example

 

XXXX is trading at $25.37 on May 10, 2011.

Buy two August 2011 25 strike puts at $1.70.

But the August 2011 25 strike call for $2.40

 

Benefit

 

The benefit of this position is that you can profit from the stock moving in either direction with capped risk.

 

Risk vs. Reward

 

The risk is limited to the net debit of the bought calls and puts. The reward is unlimited.

 

Net Upside

 

Unlimited upside reward.

 

Net Downside

 

Net debit paid.

 

Break Even Point

 

Break even up: strike plus net debit.

 

Break even down: strike minus half net debit.

 

Effect Of Volatility

 

Needs high volatility with a bearish slant.

 

Effect Of Time Decay

 

Negative. Do not keep a strip into the last month of expiration because of accelerated time decay.

 

Alternatives Before Expiration

 

If the stock drops, you can sell puts to make a profit and wait for a retracement to profit from the call.

 

If the stock rises, you can sell the call to make a profit and wait for a retracement to profit from the puts.

 

Always try not to hold position into the last month because of accelerated time decay.

 

Alternatives After Expiration

 

Close out the position by selling the calls and puts.

 

 

 
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