Riding a cresting agricultural wave?

Everywhere I see breathless commentary about the potential of the agricultural business. Unless of course, you talk to farmers.

That aside, you cannot ignore the numbers coming from Potash Corporation of Saskatchewan Inc. (symbol POT, listed TSX, recent price $153.70) and Agrium Inc. (symbol AGU, listed TSX, recent price $69.25).

POT is an integrated fertilizer, related industrial and feed products company. The company delivers about 15% of the world’s potash production, and has get this… excess capacity! When was the last time you heard that from the oil patch?

Agrium Inc. also produces fertilizer and is an agricultural retailer. It operates a network of 436 retail centers in the United States, Argentina and Chile, distributing seed, chemicals and fertilizer direct to growers in the United States.

Bottom line, both companies are in the business of increasing yields, so that fewer farms can produce more crops per acre. That’s a valuable asset because the growing middle class in emerging markets is demanding higher protein diets. Which implies the need for greater yields and high crop prices.

This plays directly into the excess capacity argument. If you accept the conventional emerging market growth story, and believe in the growth potential of alternative fuels, then excess capacity will be needed to meet that demand.

This story has been selling. POT is up more than 160% over the past year, while AGU has tacked on more than 67%. And there are those who believe that the run up is just the beginning.

They may be right. But someone looking into this sector today, or even investors who were lucky enough to buy in the early stages, may want to consider some protection. If in doubt, talk to anyone who held tech stocks at the turn of the century.

For those seeking protection, the obvious option solution is to buy puts. But with POT options trading at 55% to 60% implied and AGU options at 40% to 45% implied, the costs are high.

The alternative is to provide limited downside protection with the sale of at-the-money covered calls. Writing say, the POT March 155 calls at $5.25 or the April 155 calls at $11.35. For AGU, look at the March 70 calls at $2.55 or the April 70 calls at $4.45.

Both positions provide limited downside protection - the POT April calls protect down to $142.35, the AGU April calls to $64. Reducing the risk of high flying shares.