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Bryan Doherty: A 'fence' option strategy

An option strategy you can utilize to establish a price floor is
to buy a put option. A put provides you the right (not the obligation) to sell
at a certain level called a strike price. The dollars paid for an option are
called premium. Options trade through the Chicago Mercantile Exchange. Farmers
use options as tools in their marketing toolbox in order to shift risk or take
advantage of opportunities. One strategy you can use is called a fence. A fence
is where you buy a put and sell two call options.

As an example, if you bought a $4 corn put for 30 cents, your floor would be at
$4 minus 30 cents, or $3.70 (less commission and fees). An add-on to this
strategy is called a fence. A fence is where you are ranging in a fence of
prices. A fence sells a call option against your purchased put.

The specific mechanics of a fence strategy for downside protection are
purchasing a put and selling an out-of-the-money call. You establish a price
floor and a price ceiling for your inventory. In essence, you fence in a range
of prices. The rationale behind a fence strategy is that you put yourself in a
position to lower the cost of your purchased put. As an example, if you buy a
December $4 put for 30 cents and sell a $4.50 call for 15 cents, your net cost
at option expiration is 15 cents (less commission and fees) as long as futures
remain below $4.50. If futures are above $4.50 at expiration, you will lose the
30 cents that you invested in the $4 put and, depending on where the futures
market ends, could lose value on the $4.50 call. As an example, at expiration,
December corn is at $5. Your put would be worthless and your call would be
worth 50 cents to someone else. Therefore, your loss on the put equates to 30
cents, and your loss on the call will equate to 50 cents less premium
collected, or 35 cents (less commission and fees). Your net loss on the
position will be 65 cents (less commission and fees). Keep in mind, however,
that your cash corn had the ability to continue to gain value as well. Assuming
a zero basis, this would mean that your corn is now worth $5 less 65 cents, or
$4.35.

Before implementing a fence strategy, or any strategy for that matter, make
sure that you have a thorough understanding of the risk involved and the
requirements to hold such a position. A fence strategy can require cash flow
for margin calls. Having knowledge of how this position works can be a big help
in understanding whether or not to implement a fence strategy.

If you have comments, questions or suggestions, contact Bryan Doherty at 1-800-
Top-Farm, Ext. 129.
 


Futures trading is not for everyone. The risk of loss
in trading is substantial.  Therefore, carefully consider whether such
trading is suitable for you in light of your financial condition.  Past
performance is not necessarily indicative of future results.


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