Fence Strategy For December Corn Futures
It is not unusual for corn prices to peak sometime in the winter or early spring months. December corn futures bottomed in January at $4.35 and are currently near $5.00. More importantly, it represents an opportunity for many farmers to lock in a floor for the 2014 corn crop. This can be accomplished in many ways. One strategy we will explore today is called a fence.
The mechanics of a fence strategy is that you purchase a put option and sell an out-of-the-money call option. Typically, the put option bought is considered at-the-money, or the strike price where futures are currently trading. The call option can be at any level, yet it may be advantageous to sell a call far enough above the market to leave room for price appreciation of unpriced crop.
We will break up the put purchase and call sale for explanation purposes, and we'll use buying a $5.00 December corn put and selling a $6.00 December corn call. The buyer of a put option has the right, but not the obligation, to sell corn at $5.00. Your breakeven futures price on a put option purchase, at expiration, is the strike price less premium paid. As an example, if you bought a $5.00 put for 40 cents, you would have the right to sell futures at $5.00. Your breakeven point is $4.60. Your expiration date is in November. Anything below $4.60, and your option will be worth more than you paid for it. If corn futures stopped trading at $4.00, your put option would be worth $1.00, and your gain would be $5.00 minus $4.00 less premium paid, less commission and fees (in this example, 60 cents prior to commission and fees).
If you collect 15 cents for the call, you will reduce the cost of your put by 15 cents at expiration if corn futures are below $6.00. Your goal with the fence is to reduce the cost of the put yet leave the upside open for unpriced crop to rally up to $6.00. What happens if prices are over $6.00 at expiration? You will lose the value of the put option, and the $6.00 call will have some type of value. As an example, if corn futures are at $6.25, you will lose all of the premium on the put purchase, and the call option that you sold will be worth 25 cents. In this example, since you collected 15, you would have a net loss on the call of 10 cents plus commission and fees. Keep in mind that unpriced corn has the ability to gain value all the way up to $6.25.
In many regards, the fence strategy can be viewed as a win-win strategy if prices hold or go lower, and you have reduced the cost of your put. If prices rally, you will be eventually hedged at $6.00 (if December futures are above $6.00 at expiration). The difference between $5 and $6 is where your cash corn can increase in value.
Keep in mind, however, that a fence strategy is a marginable position. This suggests that as prices move higher, you may have to meet immediate margin call requirements. You sold this call to someone else, and at the end of the day, if their account is to be credited, the exchange is going to debit the person's account that has sold that call.