The Short Fence (Buy a Put / Sell a Call)
A. Objective:
Below is an example of a dairy farm operator illustrating the use of a Short Fence strategy to establish a price range. Following this example is a worksheet from which you can input your own values.
Assume in early July, November Class III futures are trading for $13.75 well above the top 25% of prices observed for November over the last 10 years. A dairy farm operator could take this price and hedge some of the farm's November milk production. With a round-turn broker commission of $0.10 this would imply a net Class III of $13.65 and a mailbox price of $14.75 given his mailbox/Class III basis of $1.10. This is well above his cost of production. In these tight milk supply times, the dairy farm operator believes that November prices may go even higher before USDA announces the November Class III on December 5th. He also knows that if he hedges his output he will not be able to capture these higher prices. If he doesn't hedge this operator would like to protect himself should prices in fact decline. The short fence strategy is one where he would buy an out-of-the-money November PUT (e.g., strike price is less than the futures price) and sell an out-of-the-money November CALL (e.g., strike price is more than the futures price). The purchase of the November PUT establishes a floor. The selling of the November CALL establishes a ceiling. If the Class III decreases, the buyer of the CALL will not exercise it, and the dairy farm operator can apply the premium collected from the sale of the CALL option to the lower Class III price. However, if the Class III price increases, the buyer of the CALL will exercise this option by purchasing a November Class III futures at the CALL strike price. The dairy farm operator will be required to take the opposite short position (e.g., sell a November Class III futures at the strike price) which will be cash settled at the higher announced November Class III. In order to exercise both options the producer must pay a brokers commission for the associated futures market transactions, $0.05. The following table shows how the Class III floors and ceilings are established:
Establishment of November Class III Floor and Ceiling with Current November Futures Settle Price of $13.75
| Floor Price | Ceiling Price | ||
|---|---|---|---|
| PUT Strike Price | $13.50 | CALL Strike Price | $14.00 |
| - PUT premium | $0.20 | - PUT Premium | $0.20 |
| - PUT Comm. | $0.04 | - PUT Comm. | $0.04 |
| + CALL Premium | $0.15 | - CALL Comm. | $0.04 |
| - Call Comm. | $0.04 | + CALL premium | $0.15 |
| - PUT Exercise Comm. | $0.05 | - CALL Exercise Comm. | $0.05 |
| = Floor Price | $13.32 | = Ceiling Class III Price | $13.82 |
With the establishment of the floor and ceilings, lets see how the impact of alternative announced Class III's impact the dairy farm operator. The following table shows these impacts. (Note we are assuming a $0.06 hedge commission).
| Final Class III | $13.50 PUT | $14.00 CALL | Net Class III | NET Class III if Hedged at $13.75 | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Action | Gain (+) | Prem. (-) | Comm. (-) | Futures Comm (-) | Action | Loss (-) | Prem. (+) | Comm. (-) | Futures Comm (-) | |||
| 14.80 | Let Expire | $0.00 | $0.20 | $0.04 | $0.00 | Exercise | $0.80 | $0.15 | $0.04 | $0.05 | $13.82 | $13.69 |
| 14.25 | Let Expire | $0.00 | $0.20 | $0.04 | $0.00 | Exercise | $0.25 | $0.15 | $0.04 | $0.05 | $13.82 | $13.69 |
| 13.75 | Let Expire | $0.00 | $0.20 | $0.04 | $0.00 | Let Expire | $0.00 | $0.15 | $0.04 | $0.00 | $13.62 | $13.69 |
| 12.75 | Exercise | $0.75 | $0.20 | $0.04 | $0.05 | Let Expire | $0.00 | $0.15 | $0.04 | $0.00 | $13.32 | $13.69 |
| 12.00 | Exercise | $1.50 | $0.20 | $0.04 | $0.05 | Let Expire | $0.00 | $0.15 | $0.04 | $0.00 | $13.32 | $13.69 |
From this table we see that the farm operator can not generate a higher net Class III than the above price ceiling of $13.86 or a lower price than the $13.32 floor. Had the producer hedged his November production in July, he would have been better off for lower prices but would not have been able to capture possible future higher prices.
Assume the producer's cost of production is $13.70 and his mailbox/Class III basis is $0.75. He may want to consider adopting this strategy as under any of the price scenarios above, his costs of production are more than covered. A representation of the results of the above can be seen in the following figure .
Now that you have worked through the above example, below is a worksheet that will allow you to input your own values.