Options & Futures

“I’ll gladly pay you Tuesday for a hamburger today,” cartoon character Wimpy Wellington repeatedly offers. If he worked as an options trader he’d probably say “I’ll gladly pay you 1/10th the price of a hamburger today if I can buy a hamburger, sometime in the next year, at the price they are today.” You’d answer: “but don’t you want to taste the hamburger?” “No,” he’d reply. “I’m a vegetarian but plan to sell my hamburger option to a meat-eater at a profit: I don’t really care about the burger except to the extent somebody will eventually want it.”

The options and futures market is where speculators agree to buy or sell a stock or commodity in the future, at a price set today.

Tulip Mania

The introduction of options and futures almost immediately created the most famous market bubble in history. Tulips were a popular crop from the Netherlands. They’re a perennial plant, grown from bulbs. Prices began to rise when speculators realized they could use options and futures to profit. Most traders purchased options for tulip bulbs, not actual bulbs. Because there was a limited number of plants, others repurchased the options at higher prices.

Eventually, the price of some tulip bulbs was at ten-times the annual wage of a skilled worker. Options and futures fueled the prince increases enabling traders to increase prices far faster than tulip bulbs could be produced. Eventually, the bubble burst and caused enormous losses.

Image result for tulip bubble chart

Utility Value

Options and futures were originally created, and are still used, to spread the risk of crop failure. Farmers would sell an option to purchase a crop in the future at a set price.

When the crop matures, the agreed-upon price might be lower than the market price and the farmer is forced to sell at a loss. Conversely, the agreed-upon price might be higher and the option buyer then does not purchase the crop but loses the price they paid for the option. Finally, the crop might fail in which case the farmer received at least some revenue – the price of the option – rather than nothing.

In many ways, options function similar to insurance.

Futures or commodities contracts, or derivatives thereof, make up the bulk of trading today.

Traders don’t want and wouldn’t know what to do with, for example, thousands of tons of wheat, aluminum, or pork bellies. They wouldn’t know what to do with one pork belly, much less a truck full. However, they theoretically bring stability and predictability to those who actually grow and consume various products, except when they don’t.