A Bearish Variation on a Familiar Options Play

10/15/2012 7:00 am EST

Focus: OPTIONS

Andrea Kramer

Associate Editor, Schaeffer's Investment Research, Inc.

Most options traders know the straddle strategy, and some may be familiar with straps, a bullish variation on the theme. Here, Andrea Kramer of Schaeffer’s Investment Research details a bearish variation on that same theme.

Review
Before we begin, let’s go over the basics of a long straddle position. In anticipation of a big move in the stock price (ahead of an earnings report, perhaps), many traders will initiate a straddle by purchasing an equal number of at-the-money puts and calls with the same strike and same expiration. The investor’s risk is limited to the premium paid for the two options, and profit is attainable if the shares make a monster move in either direction ahead of expiration.

The Strip

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On that note, the strip is a slightly more bearish version of the long straddle, as the trader is predicting the underlying security is more likely to decline rather than muscle higher. With the strip, the investor would purchase one at-the-money call on the stock, while simultaneously buying two at-the-money puts with the same strike and expiration.

Like the straddle and the strap, there are two breakeven points for the strip: the strike minus the net premium paid, and the strike plus the net premium paid. The trader would still profit if the equity breaches either of the breakeven levels before expiration, but stands to make more money if the stock stutters lower before options expiration.

The maximum loss on the position is limited to the initial premium paid for purchasing the three options (not including any brokerage fees or commission costs). The worst-case scenario is for the underlying equity to remain at the strike price at expiration, making all three options worthless.

For Example
For instance, let’s assume that Stewart is following Firm XYZ, which is slated to take the earnings reins in late August. The stock is prone to post-earnings price swings in both directions, and Stewart wants to capitalize on any drama on the charts. However, with the company’s history of falling short of expectations, he thinks the shares of XYZ have a greater chance of inching lower following the report. As such, Stewart decides to implement a strip, as opposed to the common straddle.

NEXT PAGE: How a Strip Works |pagebreak|

Ahead of earnings, the stock is flirting with the $80 level. As such, Stewart buys one XYZ September 80 call for $2, but purchases two XYZ September 80 puts for $1.50 each, or $3 total. The net debit on his position would then be $5 ($2 + $3), making this the most he stands to lose.

In order to avoid a loss on the position, Stewart needs the shares of XYZ to breach one of two levels: $75 (strike – net debit) or $85 (strike + net debit) by options expiration. However, since he purchased twice as many puts than calls, Stewart stands to make more on the position of the stock takes a technical tumble.

Now, let’s assume the company reports stronger-than-expected earnings, sending the shares of XYZ to the $100 level as a result. Stewart’s August 80 puts will expire worthless, but his 80-strike call will harbor an intrinsic value of $20, as it will be in the money by 20 points. Subtracting the net debit of $5 (and not including brokerage fees), Stewart’s strip position would bank a profit of $15.

On the flip side, let’s say the firm’s quarterly figures fall short of the consensus estimate, pressuring the shares of XYZ to the $60 level. The September 80 call will expire worthless, but the 80-strike puts will hold an intrinsic value of $20 each, or $40 total. Minus the $5 paid to initiate the strip position (not counting brokerage costs), Stewart’s option play would bank a profit of $35.

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In Conclusion
Strips are best suited for traders expecting the stock to make a significant move on the charts, but think the odds are greater for the equity to backpedal rather than rally. Plus, the bonus of this strategy is that even though you’re moderately bearish on the stock, you can still make a buck if the equity defies your expectations.

The premium paid—and, ultimately, the maximum potential loss—for this option play will be more than that of the straddle, though, as the investor would be purchasing more options at the start. However, as you can see by the aforementioned example, the potential reward if the stock gravitates lower may be worth it.

By Andrea Kramer of Schaeffer’s Investment Research.

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