What is a Bear Straddle?
A bear straddle is an options strategy that involves writing (selling) a put and a call on the same underlying security with identical expiration date and strike price, where the strike price is above the security's current market price.
- A bear straddle is an options strategy that involves writing (selling) a put and a call on the same underlying security with an identical expiration date and strike price.
- Unlike a typical short straddle, the strike price of a bear straddle is above the current price of the security.
- The maximum profit that can be generated by a bear straddle is limited to the premium collected from the sale of the options while the maximum loss, in theory, is unlimited.
Understanding the Bear Straddle
A bear straddle is a speculative derivative option trading strategy where the investor sells a call (short call) and a put (short put) with the same strike price and expiration date. Unlike a typical short straddle, the strike price of a bear straddle is above the current price of the security, which reveals the writer's expectation that the security's price will exhibit predominantly neutral to marginally bearish tendencies in the near term.
The put end of the straddle begins the trade in the money (ITM), while the call end starts out of the money (OTM). The writer of a bear straddle believes that the price of the underlying asset will remain, largely, steady during the life of the trade and that implied volatility (IV) will also remain steady or, preferably, decline.
The maximum profit that can be generated by a bear straddle is limited to the premium collected from the sale of the options. The maximum loss, in theory, is unlimited. The ideal scenario for the writer is for the options to expire worthless. The breakeven points (BEP) are defined by adding premiums received to the strike price to get the upside BEP and subtracting premiums received from the strike price for the downside BEP.
Upside BEP = Strike Price + Premiums Received
A bear straddle position profits only if there is no movement in the price of the underlying asset. However, if there is a broad movement either up or down, the trader could face substantial losses and be at risk of assignment. When an options contract is assigned, the option writer must complete the requirements of the agreement. If the option were a call, the writer would have to sell the underlying security at the stated strike price. If it were a put, the writer would have to buy the underlying security at the stated strike price.
When Bear Straddle Strategies Go Bad
Banks and securities firms sell bear straddles, and other short straddles, to earn substantial profits during times of low volatility. However, the loss on these types of strategies can be limitless. Proper risk management is paramount. The story of Nick Leeson and the British merchant bank, Barings, is a cautionary tale of improper risk management practices following the implementation of short straddle strategies.
Nick Leeson, the general manager of Barings trading business in Singapore, was tasked with looking for arbitrage opportunities in Japanese futures contracts listed on the Osaka Securities Exchange and the Singapore International Monetary Exchange. Instead, Leeson made unhedged, directional bets on the Japanese stock market. He quickly began losing money. To cover these losses, Leeson started selling straddles related to the Nikkei. This trade was effectively betting that the stock index would trade within a narrow band. After a Jan. 2018 earthquake struck Japan, the Nikkei sank in value. This Leeson trade and others cost the bank more than $1 billion and led to the takeover of Barings bank by Dutch bank ING for £1.