TOP FARMER WEEKLY PERSPECTIVE 10/7/2022 BY BRYAN DOHERTY
Fence Prices into Harvest
A fence is an option strategy that can be used to “fence in” a range of prices. Fences can be used to protect against down or upside price risk. Producers of a commodity would purchase a short fence (buy a put and sell a call). A long fence would be for someone who is a buyer of commodities. Long fences also lock in a range of prices and are accomplished by buying a call and selling a put. For this Perspective, we will explore a short fence strategy that a corn producer might use. Note that the examples below do not reflect commissions or fees, which may vary from firm to firm.
Let’s start with some basic definitions. A put option is purchased by someone who wants to establish a price floor. Risk is fixed to the cost of the option plus commission and fees. As an example, if you purchased a December $6.50 corn put, you own the right (not obligation) to sell futures at $6.50. However, you are not obligated to sell at $6.50. That is, if prices go higher, your unpriced cash corn can gain value. If, at expiration date of the put, December futures are above $6.50, the put would expire without value. If prices are below $6.50, you have the choice to sell the put or allow it to exercise, which means you would be assigned a December short futures position at $6.50. The cost of the option must be considered when figuring your breakeven. A sold call has unlimited risk. While you may have unpriced corn that can gain value, your hedge account is subject to margin call and unlimited loss potential.
A call option gives the owner the right (not obligation) to own futures at the strike price purchased. If someone buys a $7 call option, they have the right to own futures at $7 (not the obligation). Someone who sells a $7 call option is called the writer. In this example, if, at option expiration, the $7 call is worthless, then the seller collects all the premium. If futures end higher than $7, the call will be assigned, which means the seller gets to keep the premium and will be assigned a short futures, in this example, at $7.00. In a long fence, the short put has unlimited risk.
A corn producer would buy a short fence (buy a put and sell a call) to protect against lower prices and is also willing to accept a hedge at a higher strike price. In our example, if corn futures on option expiration date are at 6.00, the 6.50 put would be worth 50 cents and the call would go to zero. If corn futures are above 7.00, the put would lose its value and you would be hedged (short futures) December corn at 7.00. You would still collect the premium of the sold $7 call and would have lost the value of the put.
The reason the corn producer would use a fence strategy is to attempt to reduce the cost of their put by collecting premium of the sold call option. Let’s call that a win. If you buy a put for 50 cents and sell a call for 25 cents and, at expiration, futures are below $7, the call would lose its value. If the $7 call is exercised (you are assigned a short futures) because the underlying futures price closed above $7 on the last trading day, you still collect the call premium, however, you would lose the put premium. Typically, you would sell an out-of-the-money call, which means the underlying futures contract price is below the sold strike price. If exercised, this implies your cash corn has gained value.
For a fence to lose money, the market has to rally, suggesting your unpriced cash corn gains to the level of the sold call. Therefore, to be hedged at a higher price is also something we call a win.
Strategies can get complicated. Make sure you have a thorough understanding of any strategy before entering it. Have a conversation with your advisor before initiating any position, especially those that can create a margin call or expose you to unlimited risk. A fence, like any other tool in your marketing toolbox, has its pros and cons. Know them well and understand your exposure to risk. Also understand the function of the strategy in its entirety.
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.
Author
Bryan Doherty