Derivatives

Derivatives: How to create a ‘fence’ set-up

Venkatesh Bangaruswamy | Updated on April 17, 2021

Protects downside risk on the underlying by going long on put option

Last week, we discussed a strategy called switch trade which involved going long on a futures contract and simultaneously shorting an out-the-money (OTM) call on the same underlying for the same maturity. This week, we discuss ‘fence’, another combination strategy.

Limited downside

A fence, also called collar or cylinder, involves going long on a stock and simultaneously shorting an OTM call and going long on an at-the-money (ATM)/OTM put on the same underlying for same maturity.

The objective is to protect the downside risk on the underlying by going long on a put option. The cost of buying a put option can be subsidised through the premium collected on the short call. Sometimes, the premium collected on the short call will equal the put premium. In such case, the cost of setting up a fence (excluding the cost of the underlying) is zero.

Note that the number of shares you buy of the underlying should match with the lot size of the options contract or should be in multiples thereof. So, if the market lot for an option contract on a stock is 250, then you should buy 250 shares if you want to short one contract of an OTM call and go long on one contract of an OTM put on the stock.

Suppose the current price of an underlying is 14504 and the underlying is likely to face resistance at 14570. You can short the 14600 call option for 135 points.

Your short call should be one strike above the resistance level to improve the chances of the option expiring worthless. You could buy the 14400 put for 125 points.

The maximum profit on the position is the difference between the purchase price of the underlying and the call strike plus the call premium less the put premium. In the above case, that would be 106 points times the market lot.

Note that the maximum risk is the purchase price of the underlying less the put strike plus the put premium less the call premium. This would amount to 94 points times the market lot. The break-even for the position is equal to the purchase price of the underlying less the call premium plus the put premium. The position will, therefore, generate losses below 14494 i.e. the break-even price.

You should set up a fence when you are mildly bullish on the underlying yet fear a decline in the underlying. For instance, you could set up this position when the underlying has broken above a resistance level, but you are not very confident of the bulls continuing with the up trend. This could be because the breakout bar indicates the bulls may have exhausted their power to continue with the up trend.

Optional reading

The strategy can be described as long underlying, long protective put and short covered call. Time decay or theta can be favourable or could work against the position. This is because the long put will lose value with the passage of time whereas the short call will benefit from time decay.

So, if the time value of the call option is greater than that of the put option, then the position will benefit from time decay.

You can go long on Nifty 50 and Bank Nifty by buying ETFs on these indices. You can also substitute the underlying with near-month futures contract.

The advantage is that you need less capital to go long on futures compared to the underlying, as futures requires only initial margin and mark to market margin.

If you are setting up a fence on Bank Nifty and Nifty 50 indices using futures contract, then choose options that expire on the last Thursday of the month, and not the weekly options.

This is to align the expiry of the options contract with that of the futures contract.

The author offers training programmes for individuals to manage their personal investments

Published on April 17, 2021

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