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The short strip strangle is a neutral strategy employed when a trader has expectations of low volatility and a slightly bullish bias.
The trade is enacted by selling one or more out-of-the-money calls and a greater number of out-of-the-money puts. And therein lies the principal difference between the standard short strangle and a short strip strangle: the latter offers a wider safety zone between break-even points, due to the greater initial premium collected.
As the example below will demonstrate, that wider safety zone also creates an asymmetric risk/reward profile for the trade, with twice the risk incurred should the underlying break to the downside.
Bombshell Case Study
Below is a chart of military industrial giant Raytheon Co. (NYSE: RTN), whose stock has been moving in a narrowing range for several months when you decide to trade it.
By late February, you identify the trend and suspect that it will continue for some months to come. A volatile earnings season has now passed, and there’s little fundamental reason to suspect a sharp move in prices.
To that end, you decide that a short strangle would be an opportune means of generating some income, but as you feel even more strongly about the prospect of an eventual break higher, you decide to sell an additional put and turn the trade into a short strip straddle.
The Numbers
With the stock trading at precisely $125 you flick the switch (red circle). You sell one May 128 call for $2.50 and two May 122 puts for $2.50 each, for a total credit of $7.50.
Then, as you suspected, nothing happens! Or nothing so dramatic, in any event. The stock wriggles between $121 and $127 for the next two months, before veering higher to finally close at $129.20 at the May expiry.
The two short puts expire out of the money worthless, but the call ends up in the money $1.20. Just minutes prior to the close, you buy it back for exactly that amount and come away with a healthy profit.
Your total take is $630 ([$7.50 – $1.20] x 100), a very healthy haul on a stock that went precisely nowhere over a three-month span. The right strategy at the right time.
Break-Even Levels and Losses
The strategy will begin to sustain losses beyond the break-even points, which, as mentioned above, are asymmetrically situated on the price chart.
Upside break-even = the call strike + the initial premium collected (In this case, it’s $135.50 ($128 + $7.50), a full 8.4% move above the initial stock price.)
Downside break-even = the put strike – the initial premium collected/2 (In this case, it’s $118.25 ($122 – $3.75), which is 5.4% below the initial stock price.)
Traders should be aware that a $1 loss will be incurred for every $1 move above the upside break-even, while $2 in losses will be suffered on every dollar move below the downside break-even.
Additional note: The short strip strangle will also require greater margin than a standard short strangle because of the additional short option.
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