The Chicago Mercantile Exchange — Where Finance and Agriculture Meet
The Chicago Mercantile Exchange (CME) Group is a stock exchange based in Chicago that revolutionized the financial markets and brought sustainability, security, and success to farmers and buyers. Nowadays the CME sets the global standard for grain prices and creates the market prices that affect the entire worlds economy.
Last week, we talked about the CME and explained what Futures are and how they work; but most importantly we showed you how you can use them to secure your future and maximize your profits. This article we are going to go over what options are and how they work. Then we discuss how you can use them to your advantage.
Since we are going to use Futures to help explain Options, it is important you understand what futures. If you don’t then you can read our earlier article to understand futures.
Farmers can use options to make more money when they sell something, or if they want to wait before they sell something but want to ensure that they are guaranteed a certain income. An option is exactly what it sounds like. An option. It gives the owner of the option to do something, whether sell or buy. There are 2 kinds of options, Put and Call.
Put options are bought to secure the right to sell something at a certain price; think of it like an insurance policy. Say a farmer thinks that the crops are going to be good that year but doesn’t want the increased supply to affect his prices. He could a put option to give him the option to sell the grain at a certain price. But, unlike a future, the option does not force him to sell it at that price. The farmer can sell the grain for more if he was wrong and there wasn’t an increase in supply, or that the supply had no effect on the price of the grain.
Call options are bought when someone wants to guarantee the right to buy something at a certain price, but isn’t sure if they want to yet. Its kind of like an official dibs system. You can purchase the right to buy something, like X amount of Y commodity, but you aren’t obligated to buy it. Should the markets change you can then decide to not buy the product.
There are 2 ways options can be bought. Either Over The Counter (OTC) or through an exchange such as the Chicago Mercantile Exchange. OTC options are riskier than the ones through the exchange, but can be more customized. Financial institutions use these when they want to tailor an option to an exact situation. In fact, the CME is the worlds largest options market, trading nearly 1.27 billion contracts in 2014; and that number is expected to increase.
The CME is the worlds largest options market, trading nearly 1.27 billion contracts in 2014; and that number is expected to increase.
Buying an option means you are paying an premium to have the chance to buy the whole product later. If a farmer has a full grain bin of wheat and wants to sell it, someone can buy the option to buy it, or a call option. The buyer of the call option then pays the farmer an amount that is proportional to the purchase that could happen. If the grain bin is worth $100,000 then the premium might be somewhere around $3,000. That is money that the farmer gets regardless of what happens with the bin. If, come the end date of the option, the buyer hasn’t decided to buy the product then nothing happens and the farmer is free to do whatever he wants with that bin. And he keeps the $3,000. If the buyer decides to pull the trigger on the purchase then he pays the farmer the full $100,000; not including the $3,000 deposit.
Selling options can be a bit of a guessing, and mind reading, game. If you want to sell an option (like the bin) then you want to hope that the buyer a) buys the whole product quickly or b) doesn’t buy the product. If they don’t buy the product at the end of the option, then you can sell the product either as a future or another option.
Options, like futures, aren’t set in stone who is going to end up with the option. In our bin example, the farmer would put the bin on the options market and it might be bought, and sold, and bought, and sold. It could change hands 10 times before it gets to the final owner. The one who makes the decision to buy the product or not. All of this happens only if it the option is in an exchange.
The CME sets the global standard for grain prices and creates the market prices that affect the entire worlds economy.
Handy for farmers, especially during volatile times, is the option to buy a put option. If grain prices have been fluctuating a lot lately then you may want to look at put options. You lose a little bit of money at the beginning, the premium, but the peace of mind that it brings can be priceless. If wheat is at $6.52 but you are afraid it might go down, you can buy an option reserving the right to sell it at $6.51. Even if wheat drops to $4.20 you can still sell it at $6.51 minimizing your losses. But if the price goes up to $6.66 then you can sell at the higher price and make a profit. Buying an option minimizes your risk while at the same time maintaining the positives of volatility.
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