"Buy Straddle" Option Investment Strategy
The "buy straddle" option investment strategy is another form of hedging. In this strategy, the investor assumes that the price of an underlying stock is volatile - and thus, is expected to move significantly by the expiration date. Now, the investor may not really know whether the stock price will rise or fall, but the beauty of the "buy straddle" option investment strategy is that it doesn't really matter! All that matters is that the price changes significantly from where it is today by the time the expiration date rolls around.
In the buy straddle strategy, the investor buys both a "put" and a "call" option for the same underlying stock with the same strike price. The more certain an investor is that the price of the stock will move upwards, the more confident he or she can be that the higher strike option will be more profitable, since the option will have both lower premiums, and yield larger returns. Because there will be a larger difference between the original market price and the final price - the larger this gap - the higher the profits. However, if the investor perceives a bearish market, lower strike options should be purchased.
Volatile stock prices always have great potential for profit, but only when an investor knows the direction the stock is trending in. The advantage of the "buy straddle" investment tactic is that the investor still has unlimited profit potential without knowing precisely what direction the stock price will move in, while total loss is limited to price of purchasing the call and put options. So, as long as prices do not stagnate, the investor has limited risk, and a big potential for gain.
The maximum loss for an investor using the buy straddle investment strategy comes about when the option expires at the strike price and is limited to the total amount paid for the options. However, for every point above the high strike price or under the low strike price, the loss incurred also decreases by a point.
By InvestorGuide Staff