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A strip straddle is a limited loss/unlimited gain proposition that profits from a steep decline in the underlying security.
It’s composed of two legs: one long at-the-money call option and two long at-the-money puts. Because the number of puts and calls is not equal, the strip straddle is sometimes referred to as a ratio straddle. In this case, it’s a bearish ratio straddle.
Also, be aware that the strip straddle needn’t be composed of options in a strict 2-to-1 pairing. A 3-to-2 ratio – or, indeed, any other ratio that satisfies the trader’s needs – may also be employed. We use the 2-to-1 relationship here strictly for the purpose of illustration and simplicity.
Banking on a Steep Decline
The strip straddle is a strategy fraught with danger: three options purchased at the outset renders the trader in a deep hole from the start, one in which he’ll remain should the stock remain lifeless before expiry. A very strong move is required to clear either the upside or downside break-even points and move into profitability. How those break-evens are calculated is noted below.
Let’s have a look at a real-life trading example in order to better understand the salient features of the strip straddle.
This is a chart of MetLife (NYSE: MET) for a half year:
In mid-November, talks of an interest rate hike get the market jittery, and you’re expecting the financials to come under fire before too long. You just can’t be sure if the insurers will also take the heat; they, after all, have a good track record in a rising rate regimen and could buck the trend.
You decide that a strip straddle best fits with your posture, as your bias is toward the downside, though you’re not completely convinced.
With the stock trading at $51 (in red), you open with a purchase of one February 51 call for $3 and two February 50 puts for $3 each. Total debit on the trade is $9.
Two Weeks and a Lively Tumble
Within a fortnight, the stock’s on the move, and in the right direction.
MetLife shares fall to $46, recover, and then tumble again, sliding into the February expiry at a mere $38 per share (blue circle).
Your lone long call expires worthless, but the two puts end up in the money $13 each, for a net gain of $1,700 ([$13 + $13 – $9] x 100).
That’s nice. But it’s also a rarity, as $9 worth of opening premium is generally tough to recover.
Break-Even Levels
Break-even for the strip straddle is determined by the point at which the initial cost of the options is overtaken by the value of the long call (on the upside) or the two long puts (on the downside).
The exact formula for determining the upside break-even is:
- The strike price of the options + the price of each call + (the price of each put times the ratio of puts to calls)
The downside break-even is determined like this:
- (The strike price of the options – the price of the call) – (The price of the puts divided by the ratio of puts to calls)
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