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optionsplaybook.com  2 - Options Playbook

A Brief History of Options

(Aka definitely-not-boring-definitions)

There are plenty of good option traders who don’t know anything about the following historical facts. But we’ve included this section for those inquisitive souls with the drive to learn everything possible about whatever subject they choose to study.

If you fall into that category, we salute you. Join us in the trusty Way-Back Machine and let’s examine the evolution of the modern-day options market.

Tiptoe through the tulip market of the 1600s

Stock Option History 1 - Options Playbook

Nowadays, options are often used successfully as an instrument for speculation and for hedging risk. But the options market didn’t always function quite as smoothly as it does today. Let’s begin our foray into options history with a look at the debacle commonly referred to as the “Tulip Bulb Mania” of 17th-century Holland.

In the early 1600s, tulips were extremely popular as a status symbol among the Dutch aristocracy. And as their popularity began to spill across Holland’s borders to a worldwide market, prices went up dramatically.

To hedge risk in case of a bad harvest, tulip wholesalers began to buy call options, and tulip growers began to protect profits with put options. At first, the trading of options in Holland seemed like perfectly reasonable economic activity. But as the price of tulip bulbs continued to rise, the value of existing option contracts increased dramatically. So a secondary market for those option contracts emerged among the general public. In fact, it was not unheard of for families to use their entire fortunes to speculate on the tulip bulb market.

Unfortunately, when the Dutch economy slipped into recession in 1638,the bubble burst and the price of tulips plummeted. Many of the speculators who had sold put options were either unable or unwilling to fulfill their obligations. To make matters worse, the options market in 17th-century Holland was entirely unregulated. So despite the Dutch government’s efforts to force speculators to make good on their option contracts, you can’t get blood from a stone. (Or a dried-up, withered tulip bulb, for that matter.)

Stock Option History 2 - Options Playbook

So thousands of ordinary Hollanders lost more than their frilly-collared shirts. They also lost their petticoat breeches, buckled hats, canal-side mansions, windmills and untold herds of farm animals in the process. And options managed to acquire a bad reputation that would last for almost three centuries.

The birth of the U.S options market

In 1791, the New York Stock Exchange opened. And it wasn’t long before a market for stock options began to emerge among savvy investors.

However, in those days, a centralized marketplace for options didn’t exist. Options were traded “over the counter,” facilitated by broker-dealers who tried to match option sellers with option buyers. Each underlying stock strike price, expiration date and cost had to be individually negotiated.

By the late 1800s, broker-dealers began to place advertisements in financial journals on the part of potential option buyers and sellers, in hopes of attracting another interested party. So advertisements were the seed that eventually germinated into the option quote page in financial journals. But back then it was quite a cumbersome process to arrange an option contract: Place an ad in the newspaper and wait for the phone to ring.

Eventually, the formation of the Put and Call Brokers and Dealers Association, Inc., helped to establish networks that could match option buyers and sellers more efficiently. But further problems arose due to the lack of standardized pricing in the options market. The terms of each option contract still had to be determined between the buyer and seller.

For example, in the year 1895, you might have seen an advertisement for Bob’s Put Call Broker-Dealer in a financial journal. You could then call Bob on your old-timey telephone and say, “I’m bullish on Acme Buggy Whips, Inc., and I want to buy a call option.”

Bob would check the current price for Acme Buggy Whips stock — say 21 3/8 — and that would usually become your strike price. (Back in those days, most options would initially be traded at-the-money .) Then, you would need to mutually agree on the expiration date, perhaps three weeks from the day you placed the phone call. You could then offer Bob a dollar for the option, and Bob would say, “Sorry, pal, but I want two bucks.”

After a bit of haggling, you might arrive at 1 5/8 as the cost of the option. Bob would then either try to match you up with a seller for the option contract, or if he thought it was favorable enough he might take the other side of the trade himself. At that point, you’d have to sign the contract in order to make it valid.

A big problem arose, however, because there was no liquidity in the options market. Once you owned the option, you’d either have to wait to see what happened at expiration, ask Bob to buy the option back from you, or place a new ad in a financial journal in order to resell it.

Furthermore, as in 17th-century Holland, there still existed quite a bit of risk that sellers of option contracts wouldn’t fulfill their obligations. If you did manage to establish a profitable option position and the counterparty didn’t have the means to fulfill the terms of a contract you exercised, you were out of luck. There was still no easy way to force the counterparty to pay up.

The emergence of the listed options market

After the stock market crash of 1929, Congress decided to intervene in the financial market place. They created the Securities and Exchange Commission (SEC), which became the regulating authority under the Securities and Exchange Act of 1934.

In 1935, shortly after the SEC began regulating the over-the-counter options market, it granted the Chicago Board of Trade (CBOT) a license to register as a national securities exchange. The license was written with no expiration, which turned out to be a very good thing because it took the CBOT more than three decades to act on it.

In 1968, low volume in the commodity futures market forced CBOT to look for other ways of expanding its business. It was decided to create an open-outcry exchange for stock options, modeled after the method for trading futures. So the Chicago Board Options Exchange (CBOE) was created as a spin-off entity from the CBOT.

As opposed to the over-the-counter options market, which had no set terms for its contracts, this new exchange set up rules to standardize contract size, strike price and expiration dates. They also established centralized clearing.

Further contributing to the viability of a listed option exchange, in 1973 Fischer Black and Myron Scholes published an article titled “The Pricing of Options and Corporate Liabilities” in the University of Chicago’s Journal of Political Economy . The Black-Scholes formula was based on an equation from thermodynamic physics and could be used to derive a theoretical price for financial instruments with a known expiration date.

It was immediately adopted in the marketplace as the standard for evaluating the price relationships of options, and its publication was of tremendous importance to the evolution of the modern-day options market. In fact, Black and Scholes were later awarded a Nobel Prize in Economics for their contribution to options pricing (and hopefully drank a lot of aquavit to celebrate during the trip to Sweden to pick up their prize).

Some businesses start in a basement. The CBOE started in a smokers lounge.

1973 also saw the birth of the Options Clearing Corporation (OCC), which was created to ensure that the obligations associated with options contracts are fulfilled in a timely and reliable manner. And so it was that on April 26 of that year, the opening bell sounded on the Chicago Board Options Exchange (CBOE).

Stock Option History 4 - Options Playbook

Many questioned the wisdom of opening a new securities exchange in the midst of one of the worst bear markets on record. Still others doubted the ability of “grain traders in Chicago” to market a financial instrument that was generally considered far too complicated for the general public to understand. Too bad The Options Playbook didn’t exist back then, or the latter wouldn’t have been much of a concern.

On opening day, the CBOE only allowed trading of call options on a scant 16 underlying stocks. However, a somewhat respectable 911 contracts changed hands, and by the end of the month the CBOE’s average daily volume exceeded that of the over-the-counter option market.

By June 1974, the CBOE average daily volume reached over 20,000contracts. And the exponential growth of the options market over the first year proved to be a portent of things to come. In 1975, the Philadelphia Stock Exchange and American Stock Exchange opened their own option trading floors, increasing competition and bringing options to a wider marketplace.

In 1977, the CBOE increased the number of stocks on which options were traded to 43 and began to allow put trading on a few stocks in addition to calls.

Stock Option History 3 - Options Playbook

The SEC steps in

Due to the explosive growth of the options market, in 1977 the SEC decided to conduct a complete review of the structure and regulatory practices of all option exchanges. They put a moratorium on listing options for additional stocks and discussed whether or not it was desirable or viable to create a centralized options market.

By 1980, the SEC had put in place new regulations regarding market surveillance at exchanges, consumer protection and compliance systems at brokerage houses. Finally they lifted the moratorium, and the CBOE responded by adding options on 25 more stocks.

Growing in leaps and bounds

The next major event was in 1983, when index options began to trade. This development proved critical in helping to fuel the popularity of the options industry. The first index options were traded on the CBOE 100 index, which was later renamed the S&P 100 (OEX). Four months later, options began trading on the S&P 500 index (SPX). Today, there are upwards of 50 different index options, and since 1983 more than 1 billion contracts have been traded.

1990 saw another crucial event, with the introduction of Long-term Equity AnticiPation Securities(LEAPS) . These options have a shelf life of up to three years, enabling investors to take advantage of longer-term trends in the market. Today, LEAPS are available on more than 2,500 different securities.

In the mid-’90s, web-based online trading started to become popular, making options instantly accessible to members of the general public. Long, long gone were the days of haggling over the terms of individual option contracts. This was a brand-new era of instant options gratification, with quotes available on demand, covering options on a dizzying array of securities with a wide range of strike prices and expiration dates.

Where we stand today

The emergence of computerized trading systems and the internet has created a far more viable and liquid options market than ever before. Because of this, we’ve seen several new players enter the marketplace. As of this writing, the listed options exchanges in the United States include the Boston Stock Exchange, Chicago Board Options Exchange, International Securities Exchange, NASDAQOMX PHLX, NASDAQ Stock Market, NYSE Amex and NYSE Arca.

Thus, today it’s remarkably easy for any investor to place an option trade. There are an average of more than 11 million option contracts traded every day on more than 3,000 securities, and the market just continues to grow. And thanks to the vast array of internet resources (like the site you're currently reading), the general public has a better understanding of options than ever before.

In August 2007, the most important event in the history of options occurred, namely, the introduction of the The Options Playbook to the investing public. In fact, in our humble opinion this was arguably the single most important event in the history of the universe, with the possible exception of the Big Bang and the invention of the beer cozy.

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