What is a fence (options)?
A close is a defensive options strategy involving three different options an investor deploys to protect a held stake against a decline in price, while sacrificing potential profits.
A close is similar to options strategies known as risk reversals and collars which involve two options, not three.
Key points to remember
- A close is a defensive options strategy an investor deploys to protect an equity interest against a decline in price, while sacrificing potential profits.
- An investor holding a long position in the underlying asset builds a close by selling a call option with a strike price higher than the current asset price, buying a put option with a strike price at or just below the current asset price and selling a put option with a strike below the strike of the first put.
- All options in the closing options strategy must have identical expiration dates.
Understanding a fence
A close is an options strategy that establishes a range around a security or commodity using three options. It protects against large downside losses, but sacrifices some of the upside potential of the underlying asset. Essentially, this creates a range of value around a position so the holder doesn’t have to worry about market movements while enjoying the benefits of that particular position, such as dividend payments.
Typically, an investor holding a long position in the underlying asset sells a call option with a strike price higher than the current asset price, buys a put option with an equal strike price or just below the current asset price and sells a put option with a strike price below the strike of the first put. All options must have identical expiration dates.
A collar option is a similar strategy offering the same advantages and disadvantages. The main difference is that the tunnel uses only two options (i.e. a short call above and a long buy below the current price of the asset). For both strategies, the premium received by selling options partially or fully offsets the premium paid to buy the long put.
The purpose of a close is to lock in the value of an investment until the options expiration date. Because it uses multiple options, a fence is a type of combination strategy, similar to necklaces and iron condors.
Fences and collars are defensive positions, which protect a position from falling prices, while also sacrificing upside potential. The sale of the short call partially offsets the cost of the long put, as with a collar. However, selling the out-of-the-money (OTM) put option further offsets the cost of the more expensive at-the-money (ATM) put option and brings the total cost of the strategy closer to zero.
Another way to view a close is as a combination of a covered call and a bearish sell spread at parity (ATM).
Build a fence with options
To create a close, the investor begins with a long position in the underlying asset, whether it is a stock, index, commodity or currency. Options trades, all with the same expiration, include:
- Long the underlying asset
- Short a call with a strike price higher than the current price of the underlying.
- Long a put with a strike price at or slightly below the current price of the underlying.
- Short put with a lower strike price than the long put.
For example, an investor who wants to build a fence around a stock currently trading at $50 could sell a call with a strike price of $55, commonly referred to as a covered call. Then buy a put option with a strike price of $50. Finally, sell another put with a strike price of $45. All options have three months to expire.
The premium from selling the call would be ($1.27 * 100 shares/contract) = $127. The premium paid for the long sale would be ($2.06 * 100) = $206. And the premium collected on the short sale would be ($0.79 * 100) = $79.
Therefore, the cost of the strategy would be the premium paid minus the premium received or $206 – ($127 + $79) = 0.
Of course, this is an ideal result. The underlying asset may not be trading at the average strike price and volatility conditions may skew prices one way or the other. However, the net cost or throughput should be low. A net credit is also possible.