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A long marketing "fence"

12/03/2011 @ 7:27am

A fence strategy is an option strategy where you can reduce the cost of an option you are buying. The mechanics of a fence strategy are buying a put and selling a call, or buying a call and selling a put, depending on your perspective. Typically, livestock or grain producers will have an interest in buying a put and selling a call in order to protect unpriced inventory (yet to be produced, ready for market or in storage). However, the end user of a commodity, such as feed buyers, would have an interest in buying a call and selling a put. 

In this Perspective we will talk about a long fence, which is buying a call and selling a put.  This would typically be used by grain buyers or those who want to re-own sold crops.

Let’s back up for just a moment and review buying a call option. When you buy a call, you are buying an instrument that has a quantified or fixed amount of risk and gives the owner (the buyer of the option) the right, but not obligation, to be long the futures market at a specified strike price for a specified period of time. The premium paid is the most that this position can lose (plus commission and fees), if the market at expiration date is below the strike price of the call. As an example, if you buy a March $6.00 corn call, and corn prices in February (expiration month) are at $5.00, the call will have lost all its value. The benefit to the owner of the call option is that you lost only the value of the option, and avoided unlimited exposure from a long futures position, or from an actual cash sale.

If a corn producer sold corn and wants to retain ownership, he could do so by buying a call, or he could buy a call and sell a put. For example purposes, say the call costs 40 cents. If the farmer is of the mindset that he is willing to pay 40 cents now and wants to cheapen the cost, he could sell a $5.00 put for 20 cents. If at option expiration corn prices are above $5.00, the put’s value is zero. The farmer who sold this put gains all the premium. So for the farmer who sold this put and bought a call, he has reduced his cost of the call by the amount he received for selling a put.

This could be a big advantage. With a fence, either the put expires worthless or the market drops down enough where the put option now has value at expiration. If that is the case, the put option will be exercised and you will be assigned a long futures at that strike price. You still collect the premium. The call option purchased would lose all of its value. When establishing this position, the mindset has to be, “I’m willing to cheapen the cost of my call if the market stays above the strike price of the put I sold”, or “I’m willing to accept the loss on my call, and willing to be long futures at the strike price of the put I sold.” Keep in mind that selling a put will require margin dollars. You will need capital available if prices drop.

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