Thales of Miletus, Olive Oil, Tulip Mania of 1636 and the Chicago Board Options Exchange

Posted by PITHOCRATES - April 30th, 2013

History 101

Thales of Miletus was able to Predict a Bumper Crop of Olives

Italian restaurants will have a bottle of olive oil on the table.  The more authentic restaurants.  That give you a taste of old Italy.  Where they give you bread to munch on while you wait for your food.  We pour a little olive oil on a plate.  And dip our bread in it.  And enjoy that Mediterranean flavor.  Something that some of us may believe the Olive Garden brought to the dining experience.  But olive oil actually predates the Olive Garden.  We probably started eating olives for the first time around the 8th millennium BC.  When our Neolithic ancestors were still using stone tools.  Someplace in ancient Greece.

Olive trees grew all around the Mediterranean Sea.  And the Mediterranean people probably started using olive oil around the 4th millennium BC.   That’s 4000 BC.  Awhile ago.  We began to produce olive oil commercially somewhere around 2500 BC.  And began trading this luxury good.  We ate it.  Used it in religious rituals.  In medicines.  And fuel for oil lamps.  Among other uses.  As demand grew we planted more trees.  And brought in large harvests at the end of the growing season.  And took the olives to the olive presses.  And waited for our turn.  To pay the pressman to press our olives into oil.  And during a good growing season you could find yourself waiting quite awhile.

But who has time to wait?  If only we could figure out some way to avoid that long line.  Well, as it turned out, if you were smart you could.  As Thales of Miletus did.  A Greek astronomer, philosopher and mathematician.  As well as a pretty good weather forecaster.  For he was able to predict a bumper crop of olives one year because of favorable weather.  Which would make those olive presses busy at the harvest.  So he went to the olive press owners and reserved time on their presses for a nominal down payment.  So when the harvest came in he would be at the front of the line.  If he was wrong about his forecast he would give up his nominal deposit.  And walk away.  As the press owners didn’t care whose olives they were pressing they were glad to take his money for this right to buy press time later.  They had nothing to lose.  And when Thales prediction proved true and there was a bumper crop of olives those options to buy time on those presses became very valuable.  Those anxious to get their olives into the presses were glad to pay him for those options.  To buy his right to be first to buy press time.  Which he did.  Getting quite wealthy in the process.  As well as proving a point.  Rational thinking had real value.  They could use philosophy to make life better.

As Tulip Prices continued their Meteoric Rise the Speculators entered the Market to Get Rich Quick

And the option was born.  You can use them to speculate about the price of something in the future to make a lot of money.  And you can use them for hedging risk.  Such as farmers do.  They enter contracts with people to sell their crops at a set price.  Which protects the farmer if there is a bumper crop and prices fall.  Those who didn’t enter an options contract will only get the market price for their crops.  And have an unprofitable season.  While those with options contracts will be able to sell their crops above the market price.  And have a profitable season.  But if there are droughts that reduce the harvest prices will rise.  Which protects the buyer.  As he is able to buy below the market price.  At the price in the options contract.  While those buyers without options contracts will have to pay the higher market price.  Thus entering a contract hedges risk for both buyer and seller.  One party may do better than the other if there is a large swing in price.  But neither party will suffer a bad loss.  So whatever happens in that growing season they will be around for the following growing season.  But the speculators, on the other hand, can suffer great losses.

Tulips were big in the 17th century.  The affluent adorned their homes with these beautiful flowers.  And they soon became a sign of affluence.  Today people go to the affluent shops on Rodeo Drive and buy the latest in high fashion to show off their wealth.  In the 17th century they planted tulips.  People were impressed with what they saw.  And soon had to have these wonderful flowers themselves.  Causing a great surge in demand for tulips.  Which tulip growers rushed in to meet.  But the supply couldn’t keep up with the demand.  So tulip prices soared.  Soon, growers (sellers) and wholesalers (buyers) start entering options contracts to hedge their risks in the volatile tulip market.  As tulip prices continued their meteoric rise the speculators entered the market to get rich quick.  This speculation grew into such a frenzy that people would even mortgage their homes to raise money to buy tulip options.  Waiting for the big payday when they could exercise those options.  And buy tulips at one price.  Then resell them at a higher price.  A much higher price.  The demand for options grew so great that an options market opened.  And people bought and sold tulip options.

All good things must come to an end, though.  As must speculative bubbles.  And that happened in the Netherlands in 1637.  For there comes a time where buyers simply refuse to buy anymore tulips at those high prices.  And when they stopped buying people with vast amounts of tulips to sell began to panic.  And started lowering their price.  As other sellers started doing.  When interest in buying tulips fell supply began to exceed demand.  Sending the tulip price into a freefall.  With falling tulip prices no one was buying options contracts.  Because the market price was falling so fast that it would fall below the price in those options contracts.  And when they did ‘fall out of the money’ those options contracts became worthless.  And all that money the speculators poured into the options market was lost.  People lost everything.  Even their homes.  Sending the Dutch economy into a nasty recession.

With the Advent of the Internet it’s Never been Easier to Buy and Sell Options

Stock options were a way to get rich quick.  And what made them so attractive to speculators was leverage.  A small investment could turn into great riches.  But that leverage worked both ways.  And it could take that small investment and turn it into a great loss.  Should the price move in the wrong direction and fall when you have a contract obligating you to buy at a higher price.  And with the tulip mania of 1636 investors were getting a little gun-shy of options in general.  Causing the volume of options trading to fall in London.  Concerned of the speculative nature of options London made options trading illegal in 1733.  A ban that remained until 1860.

Russell Sage inaugurated options trading in the United States in 1872.  These were over the counter (OTC).  There was no central stock exchange.  Or standardized options format.  Which made the trading difficult to say the least.  Brokers placed ads in financial journals for their respective buyers and sellers.  And waited.  For someone to read the ad.  And call.  Then haggled over the price a bit.  Signed a contract.  And then waited until the expiration date of the option.  Or placed another ad in some financial journal.  To find someone else to buy the option.

Then things started changing in 1935.  The SEC granted a license to the Chicago Board of Trade (CBOT) as a national securities exchange.  And in 1968, CBOT finally did something with that license.  They created the Chicago Board Options Exchange (CBOE).  Which standardized and organized options trading.  One Nobel Prize later to Fischer Black and Myron Scholes for their “The Pricing of Options and Corporate Liabilities” we had a ‘scientific’ way for valuing stock options.  And with the advent of the Internet it’s never been easier to buy and sell options.  Allowing some to hedge risks easily.  While others live dangerously.  And speculate.  Trying to score big.  Before they lose everything trying to get rich quick.

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