What it means
Picture the price range of a share as a field. The put option builds a fence at the bottom, so if the price falls below a chosen level the holder can sell at that level.
The call option builds a fence at the top, because by selling it the holder agrees to give up any gain above a higher chosen level. A put option gives its buyer the right to sell an asset at a set price, called the strike price, before a set date.
A call option gives its buyer the right to buy at a strike price. In a fence, the investor buys the put and sells the call on the same asset and with the same expiry date, so the two work together around the asset's current price.
The reason for doing this is cost. A put alone costs a premium, which can be expensive for volatile assets.
The investor offsets that cost with the premium received from selling the call, and often chooses the strike prices so that the two roughly cancel out, which is called a zero-cost fence. Companies use fences in commodities and currencies as well as shares.
An airline might fence its fuel costs, buying protection against a price rise while selling away the benefit of a large fall. A company with foreign sales might do the same with an exchange rate, which gives it a known range for budgeting.
The trade-off is that the fence caps profit. If the asset price rises well above the call strike, the investor has to hand over those gains, and if it falls below the put strike, the put limits losses but does not remove them.
The strategy suits someone who wants certainty and a defined range of outcomes more than maximum profit.
In practice
Real-world examples.
Example
A founder holds 1,000 shares of her listed company and cannot sell for a year. She builds a fence with a put at $45 and a call at $55 to protect the value of her holding. If the price crashes to $30, she can still sell at $45.
Example
A food manufacturer worries about a rise in wheat prices. It buys a call on wheat futures to cap its cost, and sells a put at a lower price to pay for the protection. The company knows that its costs will stay within a range for the next six months.
Example
A UK exporter expects to receive $2,000,000 in three months. It uses a currency fence that guarantees a minimum exchange rate while giving up gains beyond a maximum. The finance team can set the sales budget without worrying about large currency swings.
Formula
Calculation
Net cost per share = Put premium paid - Call premium received
Maximum loss per share = (Share price - Put strike) + Net cost
Maximum gain per share = (Call strike - Share price) - Net cost
An investor holds 1,000 shares bought at $50. She buys a $45 put for $1.80 and sells a $55 call for $1.30. Net cost = 1.80 - 1.30 = $0.50 per share, or $500 in total. Maximum loss = (50 - 45) + 0.50 = $5.50 per share, which is $5,500, and maximum gain = (55 - 50) - 0.50 = $4.50 per share, which is $4,500.Case study
Seen in the real world.
Marlowe Freight is an illustrative, fictional shipping company that buys 100,000 barrels of fuel each quarter. The finance director was concerned that a price spike would wipe out profit, but the cost of simply buying protection was too high for the budget.
She built a fence by buying a call option at $80 a barrel and selling a put at $65 a barrel. The call premium cost $3.00 and the put premium received was $3.00, so the net cost was zero. Fuel costs were therefore protected above $80 and, in exchange, the company would not benefit from prices below $65.
In the quarter that followed, prices rose to $95 and the call paid out $15 per barrel, or 100,000 x 15 = $1,500,000. The illustrative lesson is that a fence trades some upside for certainty, which suited a business with thin margins.
Watch out
Common mistakes.
- Believing that a zero-cost fence is free, when the cost is the upside given up above the call strike.
- Using different expiry dates or quantities for the put and the call, which leaves part of the position unprotected.
- Forgetting that selling a call can create an obligation to deliver the asset or pay the difference.
Questions
People also ask.
Is a fence the same as a collar?
Yes, the two terms are used for the same structure, although fence is more common in commodity and currency markets.
When does a fence make sense?
When you want protection against a large adverse move and are willing to give up part of the gain to pay for it.
Does a fence remove all risk?
No, the investor still bears losses between the current price and the put strike, plus the net premium.
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