From the October 01, 2011 issue of Futures Magazine • Subscribe!

Double your option premium, balance your risk

Shorting cotton

Investors in a cotton option strangle can profit as long as cotton prices remain in a wide, predetermined range. "Trade specs" (below) details an example trade, placed on Aug. 15, 2011.

Also known as "bracketing," the strangle can be a profitable approach as long as the futures price is anywhere between the two strike prices at option expiration. The primary benefit of a strangle is this: If the market is heading toward one strike or the other, the increasing value of the nearer strike price is offset, at least partially, by the decreasing value of the option on the other side of the market. This offsetting effect allows the market greater flexibility to fluctuate as opposed to selling a straight put or call. Both the put and the call eventually will expire worthless, as long as neither strike price is exceeded.

A secondary benefit is margin. The phrase, "The whole is greater than the sum of its parts," often is true when writing strangles. The margin for writing a strangle often is less than the sum of margin for writing a naked put and the margin for writing the naked call. This concept is illustrated as such:

Margin requirement for writing March cotton 160 call:

$1,230

Margin requirement for writing March cotton 68 put:

$965

Total for writing both options:

$2,195

Margin requirement for writing March cotton 160 call 68 put strangle:

$1,820

Net margin advantage for the strangle:

$375

Thus, writing a strangle not only can be an effective tool in helping to mitigate risk by letting puts and calls balance each other, it also can increase an investor’s return on invested funds because of its favorable margin treatment by the exchanges.

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