Harness market volatility with fencing strategy, analyst says
Market volatility in the commodity complex is near an all-time high, suggesting that interest in owning and selling commodities is keeping hedgers and investors very active.
There could be many reasons for the pick-up in price action the last several months. From a big-picture ag perspective, growing world demand and, in cases, limited supply have created an environment where both bullish and bearish traders have legitimate viewpoints.
Whether it be livestock, oilseeds, or grains, the market has offered opportunities to manage high prices for the first time in several years. We all have this in common: When faced with making decisions in front of uncertainty, you hope to make the right choice. From a marketing perspective, selling rallies sounds easy, yet most producers may concede this is one of the more stressful decisions they face. If they sell too soon and prices continue to rally, they feel like they made a mistake. If they do not sell enough and prices move lower, they feel like they made a mistake. It is easy to self-destruct your competency because you can view marketing decisions as a lose/lose. If you feel this way, you might take a different approach and execute strategy.
One strategy that can allow you to be right by defending prices and still leave more upside open to sell at a higher level is called a fence. A fence is an option strategy where the producer of a commodity purchases a put to establish a price floor and sells a call option to collect premium and help finance the put. One must be willing to accept a hedge (short futures) at the higher level, even if futures prices continue to rally beyond that higher level.
Put Option Buying
Let’s start with the put buying. The mechanics of a put purchase are rather simple. The owner of a put has the right (not obligation) to sell futures. One way to think of a put option is purchasing insurance to protect against future price declines. The level of insurance is called a strike price and the dollars paid for a put is called premium. The risk is fixed to premium paid less commission and fees.
In more volatile markets, put options become expensive relative to when prices are trading without much change. Why is this? The seller of the put option is taking all the risk. He is likely betting on prices staying above the strike price of the sold put and, therefore, expecting to collect premium. If prices drop, he has the responsibility of taking on the risk of the put option gaining value against him. To reduce the cost of high volatility put options, you may consider selling a call option.
The purchaser of a call option has the right (not the obligation) to own futures. As the seller, otherwise known as the writer, you collect the premium. You also incur the risk of futures prices moving higher. As futures price move higher, the sold call could gain value and, therefore, require you to deposit dollars into your account to maintain a required cushion of funds (as determined by the exchange). This is called a margin call.
At expiration date, if the futures price is above the sold call strike price, you will be assigned a short futures. You still collect the premium. If futures are below the strike price at expiration, the call will be worth zero and you will have reduced the cost of the put by the premium collected.
As an example, let’s say you purchased the December corn $4 put for 30¢ and sold a $5 call at 15¢; if futures are below $5 at expiration, the net cost of the put is 15¢ plus commission and fees. If corn futures are above $5, you will be assigned a short futures at $5, collect 15¢ on the short call, and you’ll have spent 30¢ on the long put. The strategy establishes a floor at $3.85 or hedge at $4.85. This is where the term fence comes from, as you have fenced in a range of prices.
All strategies have costs and benefits. A working knowledge and strong communication with your adviser on how strategies can work for you to shift risk is paramount. Fences often complement good cash marketing by covering bushels you may not want to forward contract. Just be aware that, if prices continue to rally upward, you may have to deposit margin money. The short call, in theory, has an unlimited risk attached to it. With current prices at high levels, a fence may be a strategy to fit your marketing needs on a portion of bushels or livestock.
If you have comments, questions, or suggestions, contact Bryan Doherty at Total Farm Marketing. You can reach him at 1-800-TOP-FARM, extension 300.
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.