 Buy Straddle Option Strategy
When volatility is low and you are expecting a large break-
out move, but you aren't sure which way it will break out,
you might consider buying a straddle.This strategy
involves buying a call option and a put option on the
same asset at the same strike price and expiration date.
This gives you limited risk and unlimited profit potential
with a major move in either direction.
With this strategy, your potential loss is limited to the
premium you paid for the call and the put and the
commissions.
Technical indications that we look for when we buy a
straddle are a tight trading range in a triangle pattern.
This is frequently followed by an explosive move near the
tip of the triangle, but it is not always apparent ahead of
time which direction it will move. Many traders watch for
this pattern and jump on the bandwagon when it makes
its move. If you are in position with both a put and a call,
you will get a quick reward with one of the positions and
you can liquidate the other. Then ride the trend, but don't
get too greedy. Time decay works against you in this
position.
When we buy a Straddle, the put and call that we
purchase are normally at-the-money or close to it. We
look for the triangle pattern with a tightening trading
range, and initiate the position near the tip of the triangle,
so that it is in place before the break-out. This is
important because the options will be cheaper to buy
before the break-out because volatility is low due to the
tight trading range pattern. Since you are buying both a
put and a call, you want to minimize the cost of the
options. When the break-out occurs, volatility will spike
up, driving up the price of the options. We generally allow
three or more months before expiration, to provide enough
time for the market to make its move, but we just stay in
long enough to reach our target, because decay is
working against us.
It is also important to cover risks and caveats of this
strategy.
The risk of this position is limited and known. The cost of
this position tends to be higher because you are buying
both a put and a call, but by careful positioning as
described above, you can minimize this cost. Remember
that the commission you pay for this position will be
higher because you are initiating two related option
transactions. If the asset stays in the tight trading range
and doesn't break-out sufficiently during the term of your
position, you will lose money. Decay is working against
you with this position, but that is ameliorated if you
initiate the position close to, but before the break-out,
and then quickly liquidate the option on the wrong side of
the break-out.
It is important to analyze your expectations for the
underlying asset and for the market before selecting your
strategy.
When you are analyzing potential option positions, it
helps to have a computer program like Option-Aid that
swiftly calculates volatility impacts, probabilities,
statistics, and other parameters of interest. These
programs can pay for themselves with the first trade that
they help you with.
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