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The bear strangle is a long volatility, non-directional trade with a slightly bearish bias. Profits are made if and when the underlying trends strongly in either direction, but a greater haul will be registered if the move is lower (bearish).
The trade is set like a regular strangle, but with both options purchased at a slightly higher price, pulling the put closer to the money and pushing the call further away. In the event of a slide in the underlying, the put will produce profits more quickly. The call, purchased further out of the money, is acquired at comparatively less cost.
If the trader is mistaken and the stock heads higher, he is in a better position to close the initiative early and recoup his initial expenses, since neither option is too far out of the money.
Let’s look now at nine months of chart from Mattel (NASDAQ: MAT) to get a better idea of how to employ the bear strangle.
With Mattel shares toying about the $39 level for a few months now, you decide to put on a trade. You expect a breakout to occur, and though it’s likely to be lower, you’re not altogether certain of the direction.
You figure the best way to play it is with a strangle, but you’ve already decided that it will have to be adjusted “higher” to reflect your negative bias.
By early June, with the stock still changing hands at $39, you decide to set the trade (red circle). It’s a bear strangle, with expiry fixed six months out to ensure enough time to get it right. You buy the December 37 put for $3 (in black) and the December 43 call for $1 (not shown). Total debit on the trade is $4.
Tumbling Down!
The stock continues sideways for another six weeks before literally falling out of bed, gapping down better than 6% in a single day and continuing lower until the December expiry, where it closes at $29.20.
The resulting profit picture looks as follows.
The call expires out of the money worthless. But the put is in the money $7.80, leaving you with a net gain of $380 ([$7.80 – $4] x 100).
And that’s where it ends.
Of course, the trade is not going to produce anything unless there’s a significant move one way or the other. Traders may therefore want to consider tighter strikes, despite the additional cost, in order to increase the probability of a profit when all is said and done.
Break-Evens and Potential Losses
Maximum gain on the trade is unlimited, but maximum losses are limited to the initial premium expended. In this case, losses are capped at $400 should the stock settle between the two strikes, 37 and 43.
Upside and downside break-evens for the trade are calculated by adding (or subtracting) the initial cost of the trade to the call strike (or put strike). In this case, those levels arrive at $47 ($43 + $4) and $33 ($37 – $4).
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