A buy strangle is a breakout options trading strategy. It is used in times when there is low stock volatility and a large unpredictable breakout move is expected. A buy strangle is implemented by purchasing a call option and a put option on the same asset with the same strike price and expiration date. Because the stock is poised for a breakout but the direction isn’t known, buying a strangle can be an excellent strategy to use when trading stocks.
A buy strangle affords the investor a 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. It is very similar to a Buy Straddle, except that the investor is purchasing options that are out of the money, which makes the potential loss smaller because the options are less expensive to purchase. A major move in either direction allows the investor to sell the opposite option and ride the one making the money, thus resulting in highly successful trading.
When using technical analysis with candlestick patterns, and it indicates that a stock is trading in a triangle pattern, it is a prime target for a buy strangle. Frequently, with these types of stock chart patterns, 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 Strangle, the put and the call options that are purchased are out-of-the-money. After identifying a triangle trading pattern with a tightening trading range, a position is initiated near the tip of the triangle. Because stock 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. Strangle buying has excellent risk reward ratios since the actual investment risk is limited and the reward is potentially unlimited.
As with all stock option trading strategies, there is risk, though limited, in a strangle buy. The actual purchase will be 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 strangle, but it is eliminated by initiating a position before the breakout and quickly selling the option on the wrong side.
A buy strangle is an excellent tool to use in a stable market when technical analysis tools indicate 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. A buy strangle is one of several investment options that creates the potential for significant gains with limited risk of investment.
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