What Is a Strip?
A strip is a bond coupon that has been removed from the bond so that the two parts can be sold separately, as an interest-paying coupon bond and as a zero-coupon bond. This process is handled by the brokerage or other financial institution that sells the products.
A strip is also referred to as a stripped bond or a z-bond.
In options, a strip is a strategy that involves being long in one call position and two put options, all with the same strike price, in order to alleviate the potential loss.
Strips in the Bond Market
Most bonds come with the promise that interest will be paid to its owners in a series of payments, usually monthly, until the bonds reach maturity. The principal is then returned to the investor.
The interest payments are known as the coupon because they once were pieces of paper that the investor would take to the bank when a payment was due.
- A strip or U.S. Treasury STRIPS is a bond that is chopped up into a number of interest payments and a single principal payment, each of which is then separately sold to investors.
- The strip bonds and zero-coupon bonds that are produced are valued by investors seeking a low-risk savings or income vehicle.
- In options trading, a strip is a strategy used to hedge the risk of a wrong bet on a decline in a stock’s price.
The strip process separates the interest from the bond itself. The bond becomes a zero-coupon bond to be sold separately at a discount to its face value. The buyer cashes it in for face value when it matures. The difference in price is the profit.
When Strips are STRIPS
STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities. A U.S. Treasury bond is stripped by the commercial book-entry system in a process that effectively makes the interest payment and principal payment separate entities. The result is known as a strip bond or a zero-coupon bond.
Example of a Strip Bond
The U.S. Treasury issues Treasury notes that have semi-annual interest payments and mature in 10 years. The STRIPS process produces 21 separate debt securities, including 20 strip bonds and one zero-coupon bond.
The U.S. Treasury sells STRIPS that are transformed into interest payment products and zero-coupon bonds.
The minimum investment in a stripped fixed-principle note or Treasury security is $100. Any par amount above $100 has to be stripped in denominations of $100. These types of stripped bonds are attractive to investors saving save for retirement or seeking a fixed payment investment. The risk of these types of investment vehicles is extremely low.
Strips as an Options Strategy
The investor who adopts this strategy believes that the underlying price of the stock will plummet in the near-term future.
All three of the options will have the same expiration date and the same exercise price. If the investor is correct and the price drastically decreases, the puts will pay out substantially. If the investor is wrong and the price of the underlying asset increases, the call option will mitigate the loss.