What would you pay for a tulip? $3? $5? Maybe $20, but it would have to be very special. Would you believe 400 years ago, some tulips were worth the equivalent of a lavish house? When ‘Tulip Mania’ took over the Netherlands in the mid 1630s, this really happened.
The Dutch were pioneers in shipping, trade, and commerce in the 1600s. The Netherlands was a rich country and people liked to decorate with exotic and rare flowers. They fell in love with tulips! Historians believe the flower was first introduced from Turkey. Bright and colorful, the tulip was new, and prized because it was scarce.
Suppose that 1,000 people want tulips but only 10 are available, what happens to the price of tulips? Well it goes up, probably a lot! This is called ‘the law of supply and demand’ and it applies to anything which is bought and sold. If you had a tulip in the Netherlands in 1635, you could make a lot of money – more even than a nice house in her capital city, Amsterdam. Sure, it’s not gold or something of practical use, but the demand for tulips at that time was much higher than supply so the price just kept skyrocketing. How could this happen for a simple flower? Well, if everyone expects the price of something to keep going up then you can make money just by holding on to it. In fact, you can even make money by agreeing to sell something in the future, even before it exists (this is called a ‘futures market’.)
Here’s how it worked back in 1600s Netherlands: Imagine you begin to grow a tulip bulb in 1636, the height of Tulip Mania. When it blooms in 12 months, it’s going to be worth a lot of money. Just then, your friend Jenny visits and says, “Hey, I’ll pay you $100 now for that flower and when it blooms next year it’s mine.” You sign a Contract and the deal is done. You get cash now for a flower that doesn’t exist yet and you don’t have to worry about selling it later (of course, if the tulip doesn’t bloom at all you have to give back the $100.)
But Jenny didn’t really want the tulip for herself, even though it will be very pretty. Wait, what? Why did Jenny buy it if she didn’t want it? Basically, Jenny is betting that the price of the flower in one year will be much more than $100, and she will make a profit. However, it gets even weirder! Because Jenny paid $100 for a tulip ‘Contract’ (remember the tulip doesn’t even exist yet) then she can sell the Contract to Zoe who is willing to pay $200 for it because she bets it will be worth even more money in the future.
Zoe now has two choices. She can either keep the Contract and collect your tulip when grown or she can sell the Contract and try to make even more money, just like Jenny did. Zoe decides to sell to another buyer, and that buyer will sell to another buyer. Every time the Contract is sold, the price for the ‘future’ flower increases. The technical term for this is ‘speculation.’ Every buyer is speculating about what the future price will be when the tulip blooms.
It’s February 1637, and your tulip is now fully grown. Whoever holds the Contract is now the proud owner of your tulip. Who will show up at your door? Not Jenny, not Zoe, but somebody you never heard of called David. He was at the end of a chain of buyers and he paid – wait for it! – $250,000! That’s an incredible amount of money and all of the buyers along the way have made a nice profit on selling the Contract. The question now is – “how much is the tulip really worth today?” You can be sure that David is really nervous! He stands to make a lot of money if the price has gone up even more or lose a fortune if his guess was wrong.
Well, the bad news for David is that the price of tulips dropped like a stone in early 1637 and his lovely tulip is now worth only a few hundred dollars – he is ruined! This really happened in the Netherlands in 1637 and this is the first example in history of what is known as an ‘economic bubble’ – a period of frenzied speculation when everyone thinks the value of something will keep going up and up…. until the bubble pops and the price comes crashing down. No wonder it was called ‘Tulip Mania!’ But don’t get the idea this is something historical – bubbles have happened in recent years with company shares, real estate, precious metals… it can happen with basically anything.
Ok…since there is a risk of bubbles like Tulip Mania, why would anybody want to do futures trading? Let’s ask Old MacDonald.
Old MacDonald grows corn. Today, he can pay for seed and fertilizer, but he has no idea how much the corn will sell for when it’s finally grown. If he makes a contract now for his future corn, he knows exactly how much money he’ll get when he harvests his corn. This gives him confidence to spend the money he needs on seed corn, fertilizer, labor and so on. He is a farmer, after all, and not a speculator! The contract he signed may be sold on to others in the ‘Futures Market’ and there are speculators who buy and sell corn contracts in this market just like Jenny and Zoe sold the Tulip Contract. The farmer gets a stable price ahead of time and the traders can make a profit by selling for more money than they paid.
Thanks to those Dutch pioneers, we now have sophisticated Futures Markets. Farmers, miners, shareholders, real-estate builders and so on can get stable prices when they need to make investment decisions. There are Futures Markets in corn, pork bellies, cattle, wheat, in fact, just about anything! It works very well…unless things get out of hand. Just watch out for those bubbles!