Fenil's Library

The derivative strategy involves buying one call and two put options on the same stock

Hiral Thanawala

The state of affairs in the equity markets needs no reiteration. The steep fall seen in 2008 has been unprecedented. Retail investors in particular have been badly singed and are wary of entering the markets again, leave alone playing, what with the bears at large.

For all that, however, a bear market isn’t all bad, if one knows how.

One strategy that can help investors actually benefit from the ongoing bear reign is known as ‘strip’.

This is a bearish adaptation of the straddle strategy, developed on the concepts of at-the-money and in-the-money.

Let us understand a few terms before attempting to understand the strip strategy.

Strike price

This is the price at which a holder of stocks can sell to, or buy from, a writer the item underlying an option.

Example: An ABC 50 call option gives the holder the right to purchase 100 shares of ABC stock at a price of Rs 50 per share. On the other hand, an ABC 40 put option gives the holder the right to sell 100 shares of ABC at a price of Rs 40 per share.

At-the-money

Options are at the money when common stock price is equal to the strike price.

In-the-money

A call option is in the money when the strike price is less than the market price of the underlying interest.

A put option is in the money when the strike price is greater than the market price of the underlying interest.

Now that these terms are clear, let’s move to our main plot.

Strip strategy basically involves buying a number of at-the-money calls and twice the number of puts of the same underlying stock, strike price and expiration date.

Investors can benefit from this strategy whenever the market witnesses a bounce-back. Consider that the Reserve Bank of India has effected cuts in the cash reserve ratio, repo rate, reverse repo rate, prime lending rate and statutory liquidity ratio to increase the liquidity in the hands of banks and investors, while the government has announced stimulus packages for certain sectors.

This would be the right time to execute the option trading strategy (strip) if an investor is convinced that it is a bear market relief rally and the direction of the market in the near term would remain south.

Profit potential

This strategy has the potential to create huge profits when the underlying stock price makes a strong move either upwards or downwards at expiration, with greater gains to be made with a downward move.

Risk

The risk in this strategy is limited. The maximum loss for strip occurs when the underlying stock price on expiration date is trading at the strike price of the call and put options purchased. At this price, all the options expire worthless and the options trader loses the net premium and commissions paid.

Computation of breakeven points

There are two breakeven points for the strip option strategy. The breakeven points can be computed as below:

Upper breakeven point = Strike price of calls/puts + Net premium paid

Lower breakeven point = Strike price of calls/puts - (Net premium paid/2)

Example: Say the ABC stock is trading at Rs 2,000 in December. An options trader implements a strip by buying two January puts for Rs 120 per share as premium for a strike price of Rs 2,000 and a January call for Rs 100 per share as premium for a strike price of Rs 2,000.

The net debit taken to enter the trade is Rs 34,000, assuming a market lot size of 100 shares.

If the ABC stock is trading at Rs 2500 on expiration in January, the January puts will expire worthless, but the January call expires in the money and has an intrinsic value of Rs 50,000 (500 rise in per stock price x 100 lot size).

Subtracting the initial debit of Rs 34,000, the strip’s profit will be Rs 16,000.

If the ABC stock price reduces to Rs 1,500 on expiration in January, the January call will expire worthless, but the two January puts expire in-the-money and possess an intrinsic value of Rs 1 lakh (i.e. Rs 50,000 x 2). Reducing the initial debit of Rs 34,000, the strip’s profit will be Rs 66,000.

However, of on expiration in January the ABC stock is still trading at Rs 2,000, both the January puts and the January call will expire worthless and the strip will suffer a loss of Rs 34,000, which was paid as premium to enter the trade.

The two breakeven points in this case will be:

Upper breakeven point = Rs 2,000 (strike price) + Rs 340 (Rs 120 x 2 put premium + Rs 100 call premium) = Rs 2,340.

Lower breakeven point = Rs 2,000 (strike price) - Rs 170 (Rs 340, i.e. net premium / 2) = Rs 1,830.

In this example, the stock has to break the price band of Rs 1,830 to Rs 2,340 to be profitable, i.e. decline below Rs 1,830 or appreciate beyond Rs 2,340. If the stock price fails to break the price band upper and lower breakeven points, investors will end up losing the entire premium paid for executing this strategy.

The strip strategy seems to be right option trading approach for investors who are bearish on the market and expect it to correct in the near future.

 

This piece first appeared on the Apna Paisa Blog, an independent personal finance forum.