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Farmers Urged to Fence in a Range of Prices, Analyst Says
We’re approaching mid-summer, with corn and soybean producers on pins and needles.
On one hand, prices have recovered from early spring lows, and recently, seem to have lost upward momentum. As weather goes, so may prices over the next four to eight weeks.
Although this year's crop has been significantly challenged, markets have a tendency to move on perception. The perception could be that crop conditions will improve, and prices will move lower over the next month. Or, maybe there is more rally potential if less-than-ideal weather affects crop growth. Should producers sell or do nothing? Consider a fence option strategy.
In a fence, you buy a put and sell a call.
Let’s talk about buying the put first. When you buy a put, you have the right (not the obligation) to sell futures. For a fixed-risk (premium), you establish a price floor against a specific futures month. If using December futures, you're buying the right to sell futures at the strike price, a level of protection that has a contract life through November 22, 2019.
Purchasing puts makes sense for most producers, as you establish a floor and leave the topside open for price appreciation. Your bushels are not tied into a contract to deliver. If weather becomes a factor and prices move upward, your physical inventory increases in value.
Now we’ll talk about selling the call. To create the fence, you will sell an out-of-the-money call option. The reason for selling the call is two-fold. 1) You are expecting to collect premium, thereby reducing the cost of your put. 2) If corn prices were to rally, you are willing to be exercised against, with the short call converted into a short futures at the strike price. With that, your physical grain is now valued at a higher price. On the sold call, you need to be prepared to submit margin money. The exchange will require a minimum amount upfront. If the option gains value (moving against you), an additional margin requirement is necessary to maintain the position.
As an example, and based on today’s corn prices, let’s say you buy a $4.40 put for 30 cents and sell a $5.00 call for 14 cents. Provided December corn futures are below $5.00 at option expiration, your net out-of-pocket expense will be 16 cents (plus commission and fees). You collect the premium on the sold call, regardless of where December futures are at expiration. If futures are above $5.00, you lose the put premium, as it will expire without value if futures are above $4.40. You could sell your put if you believe prices are going higher. How much you get back/salvage will be determined by how much time is left, proximity to futures, and volatility. If futures are above $5.00, the call has value to the buyer, and you are subject to exercising, assigned a short futures at the strike price.
Most people will utilize a fence strategy if they believe the market could trade lower (or even a little higher), anticipating the sold call will lose all its value. In other words, if you are of the belief that corn will likely go to $6.00, selling a $5.00 call may not make sense for you. However, if you believe corn can rally, and no higher than $5.00, then this strategy may be worth your consideration.
The fence strategy gets its name from the concept that you are fencing in a range of prices. It's not for everyone. This fence, like all strategies, can be viewed as dangerous if not used properly. Options are merely tools to help market grain by shifting risk and locking in opportunity. Use marketing tools to shift risk, reduce emotion, and provide a better vision of cash flow for your operation. Doing nothing can be the riskiest of all strategies.
If you have comments or questions, or need help implementing put option strategies, contact Top Farmer at 800-TOP-FARMER extension 129 and ask for Bryan Doherty.
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.