Stripping options: market-neutral bearish strategy

The feasibility of combinations in option trading provides profit opportunities for different scenarios. Be it the underlying stock prices going up, going down, or remaining stable, suitably selected option combinations offer apt profit potential.

This article introduces “stripping options”, which is a market-neutral trading strategy that has profit potential on either side of the underlying price changes. “Strip” is essentially a slightly modified version of the long straddle strategy. The straddle provides equal profit potential on either side of the underlying price change (making it a “perfect” market neutral strategy), while the strip is a “bearish” market neutral strategy that is equivalent to an increase Compared with price, the profit potential when the price falls doubles and moves (in contrast, “belt” is a bullish market-neutral strategy).

When the price of the underlying stock moves up or down significantly at maturity, the divestiture strategy can obtain huge profits, while moving down can obtain greater returns. The total risk or loss associated with the position is limited to the total option fee paid (plus brokerage fees and commissions).

Key points

  • A divestiture is a bearish market-neutral strategy that returns relatively more when the underlying asset falls than when it rises.
  • The strip is essentially a long span, but uses two put options and one call option instead of each put option.
  • The biggest potential loss on the strip is the price paid for the option plus fees or commissions.

Strip construction

The cost of constructing a divestiture position can be high because it requires the purchase of three at-the-money (ATM) options:

  1. Purchase 1x ATM phone
  2. Buy 2x ATM put options

These options should be purchased with the same underlying, same strike price and same expiry date.

example

Suppose you are creating a divestiture option position for a stock that is currently trading at approximately $100. Since ATM options are purchased, the strike price of each option should be closest to the underlying price; let us take 100 USD as an example.

The following is the basic return function for each of the three option positions. The blue chart represents a long call option with a strike price of $100 (assuming a cost of $6). The overlapping yellow and pink charts represent two long put options (worth $7 each). We will consider the price (option premium) in the last step.

Now, let us add all these option positions together to get the following net income function (turquoise):

Finally, let us consider the price. The total cost is (6 USD + 7 USD + 7 USD = 20 USD). Since all are long options (that is, purchases), a net debit of $20 is required to create this position. Therefore, the net income function (turquoise chart) will move down by $20, providing us with the brown net income function considering price:

Profit and risk scenarios

There are two profit areas for stripping options, that is, the brown return function remains above the horizontal axis. In this example of a divestiture option, when the underlying price is higher than US$120 or lower than US$90, the position will be profitable. These points are called break-even points, because they are “break-even mark” or “no profit, no loss” points.

Generally speaking:

  • Upper breakeven point = Strike price of the call/put option + net premium paid

= $100 + $20 = $120, for this example

  • Lower breakeven point = Strike price of the call/put option-(net premium paid/2)

= $100 – ($20/2) = $90, for this example

Profit and risk profile

Beyond the upper limit of the break-even point (that is, when the underlying price rises), the trader has unlimited profit potential, because theoretically the price can move up to any level, providing unlimited profit. For every price point change of the underlying security, the trader will get a profit point (that is, an increase in the price of the underlying security by one dollar will increase the return by one dollar).

Below the lower break-even point, that is, when the underlying price falls, the trader’s profit potential is limited because the underlying price cannot be lower than $0 (the worst case is bankruptcy). However, for each downward price point movement of the underlying, the trader will gain two profit points.

This is where the bearish prospects of strip options provide better profits on the downside than on the upside. This is where the strip options differ from the usual straddle options, which provide the same profit potential on both sides.

Profit from divestiture options

If the underlying securities move up, we can calculate as follows:

Underlying price-strike price of the call option-net premium paid-brokerage and commission

Assuming that the underlying security closes at $140, the profit will be:

= $140-$100-$20-broker = $20 (-broker)

Profit from divestiture options in the downward direction

Moreover, if the price drops instead, we will calculate it as follows:

2 x (strike price of put option-underlying price)-net premium paid-brokerage and commission

Assuming that the underlying securities closed at $60, the profit would be:

= 2 ($100-$60)-$20 – Bbokerage = $60 (– Brokerage)

The risk (loss) area is the area where the brown return function lies below the horizontal axis. In this example, it is located between these two break-even points, that is, when the underlying price remains between $90 and $120, the position will lose money.

The amount of loss will vary linearly according to the underlying price, where:

Maximum loss of a divestiture option transaction = net option fee paid + brokerage commission and commission

In this example, the maximum loss = $20 + brokerage business

Other matters needing attention

The divestiture option trading strategy is very suitable for traders who expect considerable price changes in the underlying stock price, uncertain direction, but also expect a higher probability of price decline. It is expected that prices in either direction may fluctuate sharply, but the downward direction is more likely.

Ideal realistic scenarios for divestiture options trading include:

  • The company launches new products
  • Expect the company’s reported earnings to be too good or too bad
  • The bidding results of the project that the company won

In these cases, the product launch may succeed or fail, or the revenue may be too good or too bad, and the company may win the bid or fail—all of which can cause large price fluctuations. The direction is uncertain.

Bottom line

The divestiture option strategy is very suitable for short-term traders who will benefit from the high volatility of the underlying price changes in either direction. Long-term option traders should avoid this situation, because long-term purchase of three options will result in a considerable premium toward the time decay value, which decays over time. As with any other short-term trading strategy, it is recommended to maintain a clear profit target and close the position when the target is reached.

Although the divestiture position has built-in implicit stop loss (due to the limited maximum loss), active divestiture option traders do maintain other stop loss levels based on underlying price changes and indicative fluctuations. Traders need the probability of bullish or fall and choose band or band positions accordingly.

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