Fence (Investments) – Definition

Cite this article as:"Fence (Investments) – Definition," in The Business Professor, updated October 7, 2019, last accessed October 29, 2020, https://thebusinessprofessor.com/lesson/fence-investments-definition/.

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Fence (Investments) Definition

A fence is a strategy in the investment field that uses options to mitigate risks by limiting a possible range of returns. Employment of a fence takes place when an investor buys security with the following elements:

  • A long position with a financial instrument such as stock
  • A long put with a strike price either at the current spot price or close to the financial instrument
  • A short put with  a strike price below the existing spot price
  • A short call with a strike price above the current spot price

A Little More on What is a Fence in Financial Investments

In a real scenario, farmers construct a fence around a property to ensure that animals wander within the property area and do not go outside it. Likewise, a fence in finance ensures that an option movement investment returns stay within the set limit.

Investors may want to employ a fence in case there is an increase in the value of the underlying security. Employing it reduces the risk of investors incurring a loss. Upon the expiration of options, investors design the strategy to help keep the investment’s value between the short call and long put’s strike prices.

Note that the expiration date of the options is the same. So, during the purchase of the underlying security, the option premiums are supposed to balance each other. Also, its derivative investment should be zero.

In addition, a fence position sets a ceiling as well as a floor price for the limit possible losses and underlying assets for the investor. However, if the financial instrument’s price happens to drop below the strike level of the sold put, then the investor will begin taking part in any financial instrument’s additional price decline.

Also, a fence as an option strategy creates a range around either a commodity or security by use of options. Though it offers protection against substantial downside losses, it sacrifices part of the underlying upside potential of the asset.

Generally, there is a creation of value band around a given position in order for the holder not to worry when it comes to market movements. Also, he or she benefits from the position like payments from the dividend.

Fence vs. Collar Option

A collar option is the same as a fence as its benefits as well as drawbacks are the same. However, what distinguishes the two is that the collar uses only two options (short call higher and long put lower the existing asset price).

To offset the premium paid to purchase the long put for both strategies, investors apply premium resulting from selling options either in full or partial. Note that collars and fences both hold self-protective positions, which help in protecting a position from a price decline, while it sacrifices the potential for a price increase.

Constructing a Fence

In order to come up with a fence, the investor must begin with a long position when it comes to the underlying assets. The asset could be a stock, commodity, index, or currency.

Example

Let’s assume that as an investor, you wish to construct a fence around a share trading at $50 at the moment. In this case, your strike’s price of selling a call can amount to $55, usually referred to as a covered call. What follows is that you purchase a put option whose strike price amounts to $50. Lastly, you sell another put with $45 as a strike price. In this case, all options expire after three months.

To calculate the premium gained from the sale of the call will be as follows:

($1.27 x 100 shares/contract) = $127

To calculate the amount of the premium paid for the long put will be as follows:

(2.06 x 100) = $206

To calculate the premium collected from the short put will be as follows:

($0.79 x 100) = $79

So, to arrive at the strategy’s cost, you will subtract the premium collected from premium paid ($206 – $127 + $79) = 0

The above results are considered the ideal result. However, the underlying asset sometimes may not trade at the middle strike price. Also, volatility conditions can alter the prices in one way or the other.

Key Takeaways

  • A fence is a strategy in the investment field that uses options to mitigate risks by limiting a possible range of returns
  • Investors employ a fence in case there is an increase in the value of the underlying security
  • To come up with a fence when it comes to underlying assets, an investor must begin with a long position
  • A collar option is the same as a fence option because they both share similar benefits and drawbacks. What distinguishes the two is that the collar uses only two options
  • Both collars and fences both hold self-protective positions, which help in protecting a position from a price decline, while it sacrifices the potential for a price increase

References for “Fence”

https://en.wikipedia.org/wiki/Fence_(finance)

https://www.investment-and-finance.net/derivatives/b/bear-fence.html

https://financial-dictionary.thefreedictionary.com/Wing+fence

www.businessdictionary.com/definition/fence.html

www.fencingcentre.co.uk/finance.asp

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