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Buy Strangle 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 strangle.This strategy involves buying an out-of-the-money call option and an out-of-the-money put option on the same asset with the same expiration date and different strike prices. 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 strangle 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 Strangle, the put and call that we purchase are out-of-the-money to decrease our investment and risk. 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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