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A bear straddle is sometimes called a crooked straddle or a skewed straddle because it’s not set directly at the money. Rather, if the underlying is trading at $100, the straddle is set higher than the stock’s price at, say, $105. This sets the put in the money and capitalizes on any bearish bias the trader may have. At the same time, it offers a cheaper price for the call.
The bear straddle is a limited risk/unlimited gain proposition whose maximum loss is limited to the original premium outlay for the options. The trade is bullish on volatility and requires a big move in the underlying in order to move beyond the trade’s break-even markers and turn a profit. We’ll discuss exactly how to calculate those break-even points below.
Trade Composition
Like a straightforward straddle, the bear straddle is composed of a long call and a long put, both at the same strike and with the same expiry, but with the strike set above the price of the underlying and out of the money.
The following example will provide additional details and practical tips on how the bear straddle is best employed.
This is a six-month chart of retailer Dillard’s Inc. (NYSE: DDS):
With Dillard’s stuck in a sideways drift for a couple of months and news pending, you decide in mid-October that a big move will shortly be at hand for the shares (red lines).
That said, you have two concerns:
- You’re not certain which way the move will unfold; and
- Though you’d like to buy a straddle (to solve concern No. 1), you’re worried the stock won’t see enough volatility to move the trade to a profit.
You discuss it with your broker. As you’re both of the opinion that the stock is more vulnerable to a downside break, he suggests you work it using a bear straddle. That way, the put is already in the money and will be more sensitive to a southbound ride.
It’s nearly the end of the month before you dive in. With the stock trading at $88 (blue circle), you buy one January 90 put for $5 and one January 90 call for $2. Your total debit on the trade is $7.
Break-Even Parameters
A quick bit of arithmetic reveals to you that your break-even levels for the trade are $97 on the upside and $83 below. The strike price of the straddle plus/minus the premium paid determines those points.
It’s a wide gap, and if you weren’t so sure that a significant move was in the offing, you never would have entered the trade.
In the meantime, it doesn’t take too long to find out if you’re right.
Two weeks after you initiate your bet, the breakdown comes. And it’s as you expected: lower with a vengeance. Dillard’s shares drop more than 20% in four trading sessions, recover briefly, then sink like a stone, closing at exactly $65 on expiration day (black circle).
Your profit is generous. The call closes out of the money, worthless. But the put is in the money to the tune of exactly $25. That nets you a whopping $1,800 payout ([$90 – $65 – $7] x 100). And it sure feels good.
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