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Twitter A bull or bear straddle is a limited risk/unlimited gain strategy that’s often referred to as a crooked or skewed straddle, because it’s not set precisely at the money. Rather, if the underlying is trading at $100, the straddle is deliberately set higher or lower than the stock’s price. This is done in order to put one of the options in the money and thereby take advantage of any bias the trader may have.
In the case of a bull straddle, the strike is set lower than the underlying, putting the call option in the money and making it more responsive to any upside in the underlying. At the same time, the put sits further out of the money, making it cheaper to acquire.
An example trade might therefore look as follows:
- Stock ABC is trading at $100.
- Buy one ABC 95 call, and
- Buy one ABC 95 put, both with the same expiry.
Overcoming the Debit
It’s important to remember that a bull straddle is still a straddle, and therefore it requires a big move in the underlying in order to make up for the initial cost of the two long options. Indeed, this is the greatest risk of the strategy: that the stock will not be volatile enough before expiry.
Let’s have a look at a real-life example in order to better understand the trade’s strengths and limitations.
Below is a chart of health care giant Johnson & Johnson (NYSE: JNJ) for six months:
As New Year’s approaches, you’re certain Johnson & Johnson is in for a big move, though you’re not certain which way. The stock has been moving in a relatively tight band for some time, but it can’t last forever, and all your research indicates that it’s time to act now, before the breakout comes and a trend develops.
At the beginning of December, with the stock at $102, you place your bet (red circle). Because your bias is toward an upside breakout, you decide that a straight straddle is less likely to produce the fruit you’re after. You therefore veer the strike lower, two points below the current action, putting the call slightly in the money and the put decidedly out.
Cost-wise, it looks like this:
You buy one March 100 call for $3.75, and one March 100 put for $1. Total debit on the trade is $4.75.
The Earth Starts to Tremble
For roughly a month, nothing happens.
Then, volatility picks up wildly, sending the stock as low as $94 and then as high as $104 inside three weeks. By the time a trend is finally established, the options expire.
The stock closes at $107.50, your put expires worthless, but the call is in the money $7.50, offering you a nice $275 profit for your troubles ([$107.50 – $100 – $4.75] x 100).
No one gets hurt. And that’s where it ends.
Downside Danger?
The only real danger to the trade resides in the underlying failing to move beyond either of its two break-even levels, which are figured as follows: [Strike Price +/– Initial Premium Paid].
In our example, those levels emerge at $104.75 and $95.25, a fairly wide band. Any close between those levels would have led to a loss.
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