What Is a Bear Straddle?
A bear straddle is an options strategy that involves buying (or selling) both a put and a call on the same underlying security with an identical expiration date and strike price, but where the strike price is above the security's current market price.
This is a type of "crooked" or "skewed" straddle since the put will be in the money (ITM), which gives it a naturally bearish bias (for the long). A straddle traditionally uses the at-the-money (ATM) strike. A bull straddle, in comparison, would instead use a strike price below the market price.
- A bear straddle is a straddle that uses a strike higher than the current market price of the underlying security.
- This means that the put option will be in the money, giving it a natural bearish bias.
- In a traditional straddle, the strike price used would be at the money.
Understanding a Bear Straddle
A straddle is an options strategy involving the purchase (or sale) of both a put and a call option for the same expiration date and strike price on the same underlying. Unlike a typical straddle, the strike price of a bear straddle is above the current price of the security, which gives a bearish lean to the position.
The put option of the bear straddle will thus be in the money (ITM) when the position is put on, while the call starts out of the money (OTM). The buyer of a bear straddle believes that the underlying price will be volatile, with a greater tendency to drop, but will also profit from a large increase. A writer of a bear straddle believes that the price of the underlying asset will remain largely steady to slightly up during the life of the trade and that implied volatility (IV) will also remain steady or decline.
When to Use a Bear Straddle
A trader would purchase a bear straddle if they believe that the underlying security will face increased volatility, but are unsure if the resulting price moves will be to the upside or downside. With a bear straddle, the buyer would think that there is a greater probability the price will drop, but could still profit from a significant up-move.
The maximum profit that can be generated by a bear straddle seller is limited to the premium collected from the sale of the options. The maximum loss to the short, 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 ReceivedDownside BEP = Strike Price− Premiums Received
A short 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 short 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.
The maximum profit that can be earned from a short bear straddle is the premium from the sale of the options; the maximum loss is potentially limitless. The maximum profit to the long is also unlimited, but makes more initially when the underlying falls.
When Short Options Strategies Go Bad
Banks and securities firms sell bear straddles, along with other short options positions, to earn profits during times of low volatility. However, the losses on these types of strategies can be limitless. Proper risk management is paramount. The story of Nick Leeson and the British merchant bank, Barings Bank, 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 bear straddles related to the Nikkei. This trade was effectively betting that the stock index would trade within a narrow band.
After a January 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.