The history of options trading dates back to ancient Greece. The very first options contracts were used to speculate on the olive harvest. The story of how options came about begins with the story of Thales of Miletus.
Thales of Miletus
He was an ancient Greek philosopher who was born in Greek Ionia. The source for the majority of his philosophy and science can be attributed to Aristotle. Aristotle identified Thales as the first person to investigate basic principles, the question of originating substances and matter, and the founder of the school of natural philosophy.
Thales’s interests had no bounds. He studied every area of knowledge from philosophy, history, math, engineering, science, geography to politics. He proposed many different theories to explain events by nature, and the causes of those changes.
His curiosity led him to the study of patterns and formations of stars. By studying the formation and patterns of stars, Thales began to make predictions about how they could affect the growth of harvest.
What Was the First Options Contract Ever Traded?
His studies led him to believe that there would be a massive olive harvest in his area in a year when others believed there would be a shortage. He believed that the massive harvest would go on to drive demand for olive presses in his area. Thales wanted to not only test his theory but also make some money if it proved to be true.
This idea gave birth to what is now known as the options contract. The problem that Thales faced was that he didn’t have enough money to buy a large number of olive presses. He needed to come up with a method that would allow him to have ownership rights of the olive presses come harvest season. What Thales ended up doing was going to as many olive press owners as he could find and struck a deal with them.
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Thales ended up paying the olive press owners a sum of money for the rights to be able to use their olive presses during the harvest season. Many of them laughed at him and thought he was out of his mind as they were all predicting a shortage. Many of them struck deals with him out of interest, and many of them out of doubt. What they failed to understand was that Thales had gone on to create the very first options contract.
As harvest season began to approach people began talking more and more about the odd deal that Thales struck between the local olive press owners. Some olive press owners were happy to get the money now before harvest season came. Others some simply struck a deal with him because they thought he was out of his mind.
Using Options to Mitigate Risk
When harvest season came around, Thales’s prediction about the massive harvest was true.
The harvest ended up being bigger than anyone could imagine. Demand for olive presses quickly went up. Thales began to resell his rights to the olive presses to any open bidder and the money quickly came pouring in. Thales struck a deal that was not common during his time and it paid off handsomely. His prediction was true, and his business acumen helped him strike a deal that left many people speechless.
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This would essentially go down in history as the first modern-day call option. Thales paid the owners of the olive presses a premium for the right to use them during harvest season. The olive presses acted as the underlying asset and Thales later sold his rights to the olive presses to others who wanted them.
Another Instance of Options Trading in History
Another interesting instance of options contracts in history is Tulip Bulb Mania during 17th century Holland. Tulips which are native to central Asia. They became a very popular flower in the Ottoman Empire in the 16th century, especially during the reign of Suleiman the Magnificent.
During this period, they not only became a status symbol but also came to represent God. The plant was cultivated in the royal garden and displayed in a great deal of artwork.
Tulip Bulb Mania
In 1554, the tulip found its way to Europe when the Holy Roman Emperor’s pastor in Istanbul sent the first tulip bulb to Austria. Fast forward to 1593 to a famed Flemish botanist Carolus Clusius, who planted several tulip bulbs in his botanical gardens.
Over time Carolus proved their ability to grow in harsh conditions of the low country. He also discovered the tulip mosaic virus, also commonly referred to as the “Tulip breaking virus”. The virus made the flowers bloom with colors that appeared flame-like which ultimately made them more desirable.
The problem was that the plants took over seven years to properly mature. As a result, the supply could not keep up with the demand, so price inflation was somewhat inevitable.
The initial market for the plants was in the Netherlands. They had recently received their independence from Spain and thanks to overseas trade they had a stable growing middle class. This new middle-class eager to display their newfound wealth was quick to adopt the flower as a status symbol. Nevertheless, the initial price of tulips remained relatively stable up until around 1634 when French merchants began to buy tulips for their wives.
Sellers began to stockpile tulips, further increasing the price and in turn making the tulip appear as a sound investment. So, rather than planting tulips, the largely inexperienced investors began to buy them to resell which started the craze amongst the nation. This corresponded with an outbreak of the plague in the Netherlands. The plague along with casualties caused by the Thirty Years’ War created a labor shortage and an increase in wages.
The Risk of Options Trading
Some say that the fatalism that this produced made the Dutch more inclined to take risks. The sellers found ways to keep selling for the year when the plant could not be uprooted. The new merchants were trading contacts and this is the early form of what is now known as options contracts. However, these contracts were not regulated and were primarily conducted in taverns between the two parties.
So, it was rare that tulip bulbs and money ever changed hands. Instead, the buyer would have to only pay a small wine tax, roughly 2.5% of the trade and he could sell the contract for a profit later that day.
This dramatically skewed the balance between risk and reward. Therefore, throughout the winter months of 1636 and 1637, the price of tulips shot through the roof. A certain species of tulips could go as high as 2,500 gilders or roughly 15 years of pay for a skilled worker.
The smarter traders began to see the market as unmanageable and stopped reinvesting their money into it. Then in February of 1637, the bubble burst when a tulip auction in Holland failed to attract any buyers. The merchants who still had tulips were thrown into a panic and tried to now sell these worthless flowers causing the price to drop significantly.
It was made even worse because many florists had been selling tulips they did not yet own to buyers who couldn’t afford them. The Dutch government tried to step in and offer a 10% cancellation fee to void any contracts, but it did very little to prevent many people from losing a vast amount of money. However, the economic damage was not overly extensive for the state and population and the Dutch continued to expand.
This did however create a cultural legacy that was referenced through every market crash from the South Seas Company to that of the Dot Com boom.
Meanwhile, the Ottoman nobility continued to be infatuated with the plant. In the early 18th century the Ottoman went through the tulip period which saw the elite buy a lot of tulips.
Learning from the Dutch, the Ottoman government was able to effectively intervene once it began to look like a similar situation would arise in Istanbul and issue price lists. Even though the tulips fell out of favor in the Netherlands for a while, they gradually found their way to be the symbol of the country.
Russell Sage and the Resurrection of Options Trading
Since many options contracts failed to get fulfilled during this time, the Dutch lost their confidence in options contracts as a viable investment strategy. This gave options a bad reputation in the short future. Their popularity slowly began to dwindle. Options even began to get banned in several parts of the world and eventually made illegal in the 18th century. Their ban lasted up until the 19th century and was brought back to life by a man named Russell Sage.
Russell Sage was a prominent American financier and railroad advisor from New York. Sage was born in Verona, a small town in the southwestern part of Oneida County, New York in 1816. He had an impressive political career, serving as alderman in Troy and also treasurer of Rensselaer County for seven years.
He was elected to serve in the U.S. House of Representatives in 1848 and later re-elected to serve from March 1853 to March 1857. He also served on the Ways and Means Committee. The committee oversaw the jurisdiction of taxation, tariffs, and other means of raising money for government programs such as social security and Medicare.
On top of his impressive political career, he was instrumental in the formation of creating a pricing relationship between options and their underlying assets. In 1874, he bought a seat on the New York Stock Exchange and went on to introduce over-the-counter trading for options contracts