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A strip strangle, like a traditional strangle, is a neutral trade employed when a trader is expecting a big move in the underlying but is unsure in which direction it will trend. The only difference between the two is that a traditional strangle requires the purchase of equal numbers of puts and calls, while the strip strangle is a “weighted” affair, geared to produce greater profits should the underlying move lower rather than higher.
Composition
Strip strangles are composed of one or more out-of-the-money long calls and a greater number of out-of-the-money long puts. The general rule is to keep the number of options purchased to a minimum so as to reduce the overall cost of the trade. Rarely will traders employ a greater than 2-to-1 ratio of puts to calls.
The greatest danger of the strip strangle resides precisely in the fact that an additional option is purchased. The added cost means the underlying will have to move that much further into the money to ensure a profit. Proper calculation of break-even levels is therefore a must.
Break-Even Calculation
Determining how far the underlying has to move before a strip strangle produces profits is a simple matter of adding the total cost of the options to the call strike and subtracting half the cost of the options from the put strike (assuming a 2-to-1 put-to-call ratio).
The case study below will illustrate this concept, and other considerations necessary for purchasing a strip straddle.
Above is chart of Zillow Group (NASDAQ: Z), a stock you’ve been watching closely for several months. The shares have been moving in a tight range for roughly 10 weeks, but your research tells you that a breakout is imminent following the next earnings report.
You can’t be certain of direction, but your hunch is that a slide is forthcoming, and you believe the best way to play it is with a strip strangle.
On Dec. 15, with the shares spinning around $24, you get it on (red circle). You buy one February 26 call for $1.50 and two February 22 puts for $1.50 each. Your total debit on the trade is $4.50.
And you wait…
But it doesn’t take long. Just before the earnings release, the stock dumps, slides sideways, then falls into the pit, ultimately closing at $17.80 on February’s expiration.
You’re in good shape.
Your call option expires out of the money worthless, but the two puts are in the money $4.20 each, for a net gain of $390 ([$8.40 – $4.50] x 100).
Potential Losses
As mentioned above, the initial premium paid represents the greatest danger for this limited risk/unlimited reward strategy. Had the stock remained between the two break-even points, a loss would have been incurred.
Here are the break-even calculations for the Zillow trade:
Upside: $26 + $4.50 (call strike + premium paid) = $30.50. That’s a significant 27% move higher.
Downside: ($22 – [$4.50/2]) (put strike – [premium paid/2]) = $19.75. That’s still a 17.7% move, and one that, under most scenarios, would not be advisable to trade.
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