TOP FARMER WEEKLY PERSPECTIVE 2/18/2022 BY BRYAN DOHERTY
Time for a Fence?
New crop corn prices (2022 growing season) have been in a steady uptrend for months, closing in on $6.00. Old crop futures (2021 growing season) are trading near 6.50. Both are historically high prices, and there are many dynamics in play that suggest prices could move even higher. Money flow has been long the corn market for well over a year. Purchasing puts can set a price floor, while leaving the topside open. Yet, puts can be expensive due to time. If, however, you desire a futures price floor and want to reduce the cost of your put, consider a fence strategy. A fence is where you purchase a put and sell a call option. By selling the call, you are intending to collect the premium and reduce the premium paid for your put or, you are willing to accept the short call to be exercised (turned into a short futures) at a higher level. In essence, you have “fenced” in a range of prices. Some refer to this strategy as a min max and others a collar.
Every strategy has its pros and cons, and work best in different scenarios. Fence strategies are best incorporated in two scenarios. You either believe prices are near a top and will turn lower, or you hope prices will move higher. If price move higher, you must be willing to allow the short call to exercise and, in turn, be assigned a short futures at the sold call strike price. The put will lose its value, while unpriced cash corn increases in value as the market moves higher.
Let’s use an example. (Note that prices are for example purposes only.) Say December futures are at $6. You buy a December $6 corn put and sell a $7 corn call. You pay 50 cents for the put and sell the call for 25 cents. Fast forward to expiration date (last trading day being November 22 for December 2022 options). December corn futures are at $5.00. The put you bought will be worth $1.00 and the sold call will expire without value. Your net futures price is $6.00 – 25 cents (from put premium paid and premium collected) or $5.75, less commission and fees. Your unpriced cash corn lost value.
What if December corn is at $7 on expiration date? The bought put is worth zero and so is the short call. You lose 25 cents plus commission and fees. Your unpriced corn was able to participate in higher prices. If December futures are higher than $7, then the short call will be exercised (the owner turns it into a long futures at $7) and you will be assigned a short December futures at $7. For example, if December corn is at 7.25, the net of the position is a short futures at $7, loss of 50 cents paid for the put premium and gain on short call premium of 25 cents. Your net position if futures are at $7.25 is $6.75. In fact, at any level where December futures are above $7, your net is 6.75 less commission and fees.
Fence strategies also entail margin call. The exchange views a short option as marginable and a risk position, in which margin must be maintained. You must be prepared to meet margin in a timely manner. From a longer-term perspective, however, fences may be a good strategy. They may allow you to own a more valuable put option, if you are willing to meet margin, establish a price floor, or be willing to hedge at a higher level. Ultimately, you are attempting to reduce the cost of the purchased put while leaving a window where your unpriced corn can increase in value.
Before entering into a fence strategy, prepare yourself for all that’s involved. Talk to a trust advisor to see how this may work in your operation.
If you have any questions on this Perspective, feel free to contact Bryan Doherty at Total Farm Marketing: 800-334-9779.
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