Strip and strap strategy
Strip and strap are the strategies to deal with the options. There are specific differences in the approach and the investors’ expectations while deciding on an investment. Let’s explain the concept of how these strategies work and generate profit for the investor.
The strip is a market-neutral bearish strategy, which means that the investor expects the underlying asset’s price to decrease in the future. So, the subscription is made for two put options and one call option. Keeping in mind the investor’s bearish expectation, the strip provides more proportion to sale at the strike price if the underlying asset price decreases. It’s not like the investor will not make a profit if the underlying asset price goes up. However, he’ll not be able to make the same profit as in the price movement in the down direction. He has got more proportion of the put options that generate profit when the underlying security moves down.
Further, the maximum potential of the loss for an investor in strip strategy is limited to the price paid for the options and some commission or fee, etc. as an investor is not expected to be profitable of there is no higher fluctuation in the price because the movement of the opposite option will set off the small subscription. For instance, if the fee of the underlying security moves up slightly, the call option can be exercised, but it only covers the loss on the premium paid for the put option. Hence, there is no profit.
In addition to this, it’s important to note that the underlying asset, strike price, and expiry date should be the same for both put options and one call option to make it a strip strategy.
Example of the strip strategy
Consider current share price of the Alpha Company is USD 40, which is currently trading on the stock. The investor enters the strip strategy, pays the premium of USD 400 for the 200 put options at a strike price of USD 40, and pays a premium of USD 200 for 100 call options at USD 40. The total premium paid for getting the strip position is USD 600 (400+200)
Both call and put options have the same date of expiry.
So, if at the date of expiry, the share of the alpha company (underlying security) is trading at USD 50. The premium paid on the put options amounting to USD 400 is a straight loss. However, the 100 call options generate a value of USD 1,000 (10*100). After deduction of the initial premium paid, the profit from the strip arrangement amounts to USD 400 (1,000-600). Hence, the trader got a net profit from the arrangement.
On the other hand, if at the date of expiry, the share of the alpha company (underlying security) is trading at the price of USD 30. The premium paid on the call option a straight loss amounting to USD 20. However, put options generate the value of 2,000 (10*200). After deduction of the initial premium, the profit for trader amounts to USD 1,400 (2,000-600).
An important point to note is that the profit is more when the price shift is downwards. It’s because strip strategy is based on the concept of bearish and expects the market to fall significantly.
There can also be another interesting situation when the trader faces a complete loss of the premium paid on both the call and put options. Consider that the price of the alpha company’s shares (underlying security) does not change. Hence, both call and put options are a straight loss for the investor, and they have dame a loss to the extent of the premium paid amounting to USD 600.
This strategy is the opposite of the strip strategy and bullish in nature as investors expect the market to move upwards. So, this strategy earns more profit when the market price moves up for the underlying asset. This strategy uses one put and two-call options as it’s bullish in nature and expects traders to purchase the underlying security at the lower price (strike price) when the actual market price has moved up. Hence, there is more proportion of the call options than put options.
The mechanism of profit generation from the strap strategy is the same as the strip strategy. The basic difference is that more profit is generated when prices move in up direction.
Example of the strap strategy
Consider the current share price of the Gamma plc is USD 40, and the traders enter in a contract for the 200 call options with a strike price of USD 40 and premium amounting to USD 400. Simultaneously, the trader enters a contract for the 100 put options with a strike price of USD 40 and premium amounting to USD 200. Further, the date of expiration is the same for both of the options. Since the proportion of the call options is double that put options, it’s a strap strategy.
So, if at the date of expiry, the share price of the gamma plc (underlying asset) increases to USD 50. The premium paid on the put options is a straight loss amounting to USD 200. However, call options to produce value amounting to USD 2,000 (200*10) and remaining profit after deducting the premium expenses is USD 1400 (2,000-600).
On the other hand, if the share price of the gamma plc (underlying asset) decreases to USD 40. The premium paid on the call options is a straight loss amounting to USD 400. However, the put options generate value amounting to 1,000 (100*10). After deduction of the premium, the profit of the trader amounts to USD 400 (1,000-600).
Further, if the strike price of the underlying assets remains the same as the current trading price, it’s a situation of loss for the trader, and they have to bear the maximum loss to the extent of the premium paid on getting strap position.
In addition to this, here is a critical point to note that the options trader has generated more profit when the prices have increased as it’s bullish in nature and contains more proportion of the call options. On the other hand, the strip was bearish in nature with more proportion of the put options.