Like other volatile options trading strategies, the strip strangle is designed to be used when you are forecasting a significant move in the price of a security. Most volatile strategies are constructed in a way so that you'll make roughly the same amount of profit whichever way the price moves; however the strip strangle will return greater profits if the price of the security moves down rather than up.
Therefore, it's best used when your outlook is volatile but with a bearish inclination i.e. you think a downward price movement is more likely than an upward price movement.
It shares many characteristics with the long strangle, but it involves buying more puts than calls. We would advise that you are familiar with the long strangle before you start learning about the strip strangle. If you are not, then please take a look at this page first. Further information on the strip strangle can be found below.
- Volatile Strategy (with bearish inclination)
- Suitable for Beginners
- Two Transactions (buy calls and buy puts)
- Debit Spread (upfront cost)
- Low Trading Level Required
When & How to Use a Strip Strangle
As we have already said, the strip strangle is best used when you a have volatile outlook with a bearish inclination. It will return a profit if the underlying security makes a big price movement in either direction, but the profits will be higher if the movement is down rather than up.
Therefore, the idea is that you would use this strategy when you are confident that there will be a big price movement and expect that movement to be downward and want to profit if the price goes up significantly. Applying strip strangle is simple enough, with just two transactions involved. You need to buy out of the money calls and a larger amount of out of the money puts, and then you have two main decisions to make.
First, you must decide what ratio of puts to calls to use. There's no particularly correct ratio, but we would suggest that you keep things relatively straightforward and use a 2 to 1 ratio. Second, you must decide how far out of the money you want the options to be and, again, there's more than one correct move to make.
If you choose options that are way out of the money, then the upfront cost will be lower than if you choose ones that are very close to the money. However, you'll need to see a greater price movement for the strategy to return a profit. In our opinion, you are better off using options that are close to the money. You should ideally ensure that the strike of the calls and the strike of the puts are equidistant from the current trading price of the underlying security.
Example of the Strip Strangle
We have provided an example of how you might apply the strip strangle below. We have used rounded figures rather than real market data and we haven't included commission costs to keep the example as simple as possible.
- Company X stock is trading at $50, and you believe the price will make a significant move, probably in a downward direction.
- Out of the money call (strike $51) are trading at $1.50. You buy 1 contract of these (containing 100 options), at a cost of $150. This is Leg A.
- Out of the money puts (strike $49) are trading at $1.50. You buy 2 contracts of these, at a cost of $300. This is Leg B.
- You have created a strip strangle for a net debit of $450.
- If Company X stock is still trading at $50 by the time of expiration, then the options in both legs will expire worthless and you will lose your initial investment of $600.
- If Company X stock is trading at $52 by the time of expiration, then the calls in Leg A will be worth $1 each ($100 total) while the puts in Leg B will expire worthless. The $100 value of the calls will partially offset the $450 net debit for a total loss of $350.
- If Company X stock is trading at $56 by the time of expiration, then the calls in Leg A will be worth $5 each ($500 total) while the puts in Leg B will expire worthless. The $500 value of the calls is greater than the $450 net debit and you will have made a $50 profit overall.
- If Company X stock is trading at $48 by the time of expiration, then the calls in Leg A will expire worthless while the puts in Leg B will be worth $1 each ($200 total). The $200 value of the puts will partially offset the $450 net debit and you will lose $250.
- If Company X stock is trading at $44 by the time of expiration, then the calls in Leg A will expire worthless while the puts in Leg B will be around $5 each ($1000 total). The $1000 value of the puts is greater than the $450 net debit, and you'll have made a $550 profit overall.
Profit, Loss & Break-Even Calculations
The following calculations apply to the strip strangle.
- Maximum profit is unlimited and profit is made when “Price of Underlying Security > (Strike of Leg A + Price of Each Option in Leg A + (Price of Each Option in Leg B x Ratio of Puts to Calls))” or when “Price of Underlying Security < (Strike of Leg B – Price of Each Option in Leg A - (Price of Each Option in Leg B / Ratio of Puts to Calls))”
- The strip strangle has an upper break- even point and a lower break-even point.
- Upper Break-Even Point = “Strike of Leg A + Price of Each Option in Leg A + (Price of Each Option in Leg B x Ratio of Puts to Calls)”
- Lower Break-Even Point = “(Strike of Leg B – Price of Each Option in Leg A) – (Price of Each Option in Leg B / Ratio of Puts to Calls)”
- The strip strangle will return a loss if “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
- Maximum loss is limited to the initial investment and occurs when “Price of Underlying Security < Strike of Leg A and > Strike of Leg B ”
The strip strangle is simple enough for beginner traders to consider using, with only two transactions involved. It's slightly more complicated than the long strangle, but it's an excellent alternative if your expectation is that the price of the underlying security is more likely to drop significantly than rise significantly. There's no margin requirement and you will only need a low trading level.