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Bryan Doherty: A 'fence' option strategy

Agriculture.com Staff 07/22/2010 @ 11:00pm

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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