Derivatives can be a powerful tool for making money and for hedging risk.
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This article introduces strips and straps, how they are created, and how investors profit from their designs.
A strip is an option strategy that involves the purchase of two put options and one call option all with the same expiration date and strike price. It can also be described as adding a put option to a straddle.
Like straddles, strips attempt to capitalize on large price movements of an underlying stock. However, for whatever reason, investors pursuing a strip strategy believe that the stock price is more likely to decrease than increase. Consequently, they purchase two puts to double their potential profits from any decreases in the stock's value.
The chart below shows the profit profile of a strip involving two put options and a call option with the same expiration date and strike price of $40. Because this strategy involves purchasing three options at $200 each, the investor begins out of the money $600. Only when the stock price deviates away from the strike price do investors start to recoup their initial investment.
However, if the stock price decreases, the investor gains twice as much profit than if the stock value increased. The price only needs to fall to $37 for the investor to break-even. On the other hand, the price would need to increase to $46 before the strategy becomes at-the-money. While the downside profit potential is limited to $7,400 since zero is as far as the stock price can decrease, the upside profit potential is unlimited since the stock price can rise indefinitely.
A strap is an option strategy that involves the purchase of two call options and one put option all with the same expiration date and strike price. It can also be described as adding a call option to a straddle.
Like strips and straddles, straps try to profit from large deviations of a stock's value from the strike price. However, opposite of strips, investors pursuing a strap strategy believe that the stock price will more likely increase rather than decrease. For this reason, straps involve two call options that will double the profits from any increases in the stock's value.
Like the above strip, the strap example below involves the purchase of three $200 options with the same expiration date and $40 strike price. Therefore, this strap is $600 out-of-the-money at the strike price and will only gain value from the stock price fluctuating in either direction. However, if the stock price increases, the investment will gain value twice as fast as if the stock price decreased. While the upside profit potential is unlimited and starts at the break-even point of $43, the downside profit potential begins at $34 and is limited to $3400.
Worth noting, strips and straps are even more difficult to profit from then straddles since they involve an additional option.
Investors need to be optimistic that the volatility in the stock will occur during the short lives of the options. Preferably, the movement will occur towards the leveraged side. If the hoped for price swing does occur, these strategies can be quite rewarding.