Buy straddle is a breakout options trading strategy. In times when there is low stock volatility and a large unpredictable breakout move is expected, a successful trader might consider making a straddle buy. A buy straddle is implemented by purchasing a call option and a put option on the same asset with the same strike price and expiration date. Buy straddle can be an excellent strategy to use when the stock is poised for a breakout but the direction is unknown.
A buy straddle affords the investor limited investment risk, while offering an unlimited profit potential on a major move up or down. In such a strategy, the potential loss is limited to the premiums paid for the call and the put as well as commissions. A major move in either direction allows the investor to sell the opposite option and ride the one making the money, thus creating a highly successful trading situation.
When technical analysis indicates that a stock is trading in a triangle pattern, it is a prime target for a buy straddle. Frequently with this type of trading pattern an explosive move occurs near the tip of the triangle, but the direction of the move is not readily known. Since the call and the put cover both directions of movement, a reward is quickly realized in this maneuver. Once the direction is known, the other option is liquidated and the investor can ride the trend. At this point, it is important not to ride the trend too long since time decay works against the trade in this position.
When buying a straddle the put and the call that are purchased are either at-the-money or close to it. After identifying a triangle trading pattern with a tightening trading range, a position is initiated near the tip of the triangle. Because volatility is low, the options will be cheaper before a breakout occurs. Since this technique requires buying both a put and a call, buying before the spike is even more important. Straddle buying has excellent risk reward ratios since the actual risk is limited and the reward is potentially unlimited.
As with other stock option trading strategies there is risk, though limited, in a straddle buy. The actual purchase is more costly since both a put and a call are being purchased on the same option. If the option fails to break out before the expiration date of the call and put, the trader will lose money on the purchases. Decay is also a factor working against a buy straddle, but it is eliminated by initiating a position before the breakout and quickly selling the option on the wrong side.
A buy straddle is an excellent tool to use in a stable market when technical analysis indicates that a stock is ready to break out of a triangle trading pattern. In such a case, the trading range is very tight and the stock is likely to make an explosive move. Buy straddles create the potential for significant gains with limited risk of investment.
Be sure to also read about a buy strangle, another breakout options trading strategy used when trading stocks.
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