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Bryan Doherty: Be careful

03/11/2011 @ 4:39pm

Last week, I attended the Commodity Classic in Tampa, Florida. After listening to speakers provide analytical breakdown of the markets, my impression was that most had a generally optimistic price outlook. Yet I came away with the idea that farmers should focus on strategy over outlook. The market is offering historic opportunities and risk. There were a few recommendations by advisors in which CALL option selling opportunities were suggested. We'll focus our attention on these strategies because, in a year with tight supply, we want you to be prepared for most anything to happen. 

Specifically we will address the fence strategy. Top Farmer has used this strategy on numerous occasions and continues to believe strongly in the merits of a fence. From a defensive standpoint, a fence is when you purchase a PUT option and sell a CALL option in an attempt to capture time value erosion on the CALL option, which would then reduce the cost of the PUT. If prices rally, you are subject to margin call on the short call with unlimited risk. Is that bad? Not necessarily. If you have very few or no cash sales, in order to have a call option work against you, the market has to rally and, therefore, your net worth increases. However, in a year of short supply, you could quickly incur significant margin calls. Or, in some cases where you have many trigger points above the market to sell cash, you could suddenly end up with more corn sold than anticipated. This isn't a very comforting feeling if markets are locked limit higher. Therefore, before employing a fence strategy and leaving yourself exposed to unlimited risk and margin calls, make sure that you have a thorough understanding of where you are on cash sales. We have seen plenty of times in bull markets where farmers may go from, let's say, 25% sold to quickly 60% to 70% because their trigger points were hit. In some cases, there are contracts offered through cash buyers in which your number of contracts sold may double if prices move higher.

The biggest dilemma we see in 2011 is simply there is not enough inventory to handle any crop threat, let alone an actual weather market. Corn prices could rapidly double from $6 a bushel in December to $12 if the market feels that carryout could drop to under 500 million bushels. The current USDA estimate is 675 million. The market won't run out of supply, though it will have to ration it. If you're not prepared to get caught up into a bull market with short CALL options, then the fence strategy is not for you. If you use a fence, you may consider a trigger point to manage your risk and buy back your short call. Or have some type of a safety valve long CALL option that could be significantly farther out of the money. This could be a safety valve that could save you a lot of heartache and headache if prices were to explode. Just one look at the cotton market suggests that is possible.

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