From Ancient Greece to Wall Street: A Brief History of the Options Market
Equity and index listed options are some of the most actively traded financial products, with millions of contracts tied to billions of shares traded each day. Their history as standardized, exchange-traded securities subject to regulatory oversight, however, is surprisingly short.
Chicago Board Options Exchange, the oldest U.S. options exchange, is less than half a century old — far younger than its Chicago-based futures counterpart, the 167-year-old Chicago Board of Trade. The concept of trading an option, though, dates back to at least 350 B.C., by some accounts.
Let’s take a look at how listed options products came to be what they are today.
Options and futures are close cousins, but options (as their name implies) come with flexibility.
A future is a contract that carries the obligation to buy or sell an asset — say, a physical commodity like a bushel of corn or a financial instrument like an amount of a foreign currency — at a fixed price on a designated date in the future. Once you enter into a contract, you have to either hold up your end of the bargain (i.e., deliver the asset obligated by the contract, in the case of a futures contract sale, or to pay for delivery of the asset in the case of a purchase) or trade out of the futures contract.
An option, on the other hand, conveys the right, but not the obligation, to buy or sell an asset at an established price by a designated date. The buyer of an option can either exercise that contract on or prior to its expiration date in the case of American-style contracts, trade out of the contract, or simply let it expire.
The origin of both products is closely tied to a host of commodities, ranging from olives to tulips, onions to grains.
Some believe that options contracts date before 350 B.C., when Aristotle in Politics told the tale of Thales of Miletus, a philosopher and mathematician who made a fortune by snapping up options on the right to use olive presses right before a particularly strong harvest.
In the Middle Ages, some Mediterranean area traders also developed credit contracts that were similar to options, where the seller of the contract agreed to purchase cargo if the ship carrying the cargo didn’t come in on time for the intended purchaser’s needs.
Futures and Options Diverge
But the fates of options and futures ultimately diverged, with futures contracts becoming standardized and regulated in the United States long before options, largely due to the fact that America’s agricultural industry demanded something more uniform and regimented.
In 1848, the Chicago Board of Trade opened its doors. Located in a rapidly growing city smack in the middle of America’s heartland, the CBOT offered a solution to seasonal price risk in the agricultural industry.
The CBOT allowed for the trading of “to-arrive” contracts (or “forward” contracts), which allowed farmers to fix a price and delivery date ahead of time, so they could store their product elsewhere until the expected delivery date, centralizing what had been a disperse process.
By 1865, the Board of Trade standardized its contracts, transforming the forward contracts marketplace into a standardized futures contract marketplace with uniformity in expiration dates, contract quality and pricing, leaving a product very similar to the futures that trade today.
In the century that followed, futures grew more uniform and in the U.S., more regulated. The Grain Futures Act of 1922 created a predecessor to the Commodity Futures Trading Commission, and the first mandatory clearing system to settle trades was established in 1925.
Options, The Late Bloomers
Options, on the other hand, remained unstandardized and largely unregulated in the U.S. and internationally. Options had strong critics due to some of notable cases where the inability to require counterparties to fulfill their obligations led to big losses on what should have been a profitable position, and in some parts of Europe they were actually outlawed..
Without a standardized market, each option contract and each term of the contract – strike price, expiration date and cost — had to be individually negotiated. It wasn’t until the late 19th century that New York-based financier Russell Sage put forth a method of pricing options in relation to the price of the underlying security and interest rates, creating a form of standardized pricing, according to Louisiana State University professor of finance Don Chance.
However in the early 1900s, options-focused boiler rooms, fraudulent brokerage houses that peddled speculative or fake securities, popped up across the country, according to Chance, leaving a number of jilted investors in their wake and leaving the options industry unpopular with investors.
The Age Of Regulation
The stock market crash of 1929 led to a wide-ranging overhaul of financial regulation. The Securities Act of 1933 created a broad set of regulations governing securities trading while the Securities Exchange Act of 1934 created regulations governing the operation of securities exchanges and created the U.S. Securities and Exchange Commission to enforce the new rules.
The Chicago Board of Trade applied for registration as a national securities exchange shortly after, and received a license as such. But that license went unused for more than three decades as the market continued to trade non-standardized privately negotiated options contracts. The Put and Call Brokers and Dealers Association was formed around this same time to better organize the over-the-counter markets.
It wasn’t until the 1960s, in the midst of a grain market crisis, the CBOT finally put its exchange license to use as it looked to expand its business to include options. The resulting spun off entity, the Chicago Board Options Exchange, established open-outcry trading pits similar to those at its affiliated futures exchange and centralized options clearance and settlement.
In 1973, not only did the CBOE open its doors, but two economists, Fischer Black and Myron Scholes, published an article putting forth a model for calculating the theoretical estimate of an options price over time. At the same time, their colleague Robert Merton published an additional study and mathematical amplification of the Black-Scholes model. The Black-Scholes model so changed the landscape for the pricing of options that Myron Scholes and Robert Merton were awarded the Nobel Prize in Economics for their work years later, in 1997.
With an exchange created and a solid model for pricing, new options contracts were issued subject to standardized terms, such as uniform expiration dates and established “strike” prices, or the price at which the option could be exercised. The market flourished and was subject to regulatory oversight on par with U.S. stock markets, with trades guaranteed by a central clearing house, The Options Clearing Corporation.
The Modern Landscape
In 1973, options trading at the CBOE was restricted to call options, which grant the right to buy shares, in just 16 stocks.
Over time, the listed options market has expanded to additional exchanges and products, including put options, which grant the right to sell shares, and cash-settled index options, which allow investors to manage or hedge portfolio exposure and smooth portfolio returns against indexes like the broad based S&P 500 and Russell 2000, or narrower indexes like the NASDAQ-100. More recently, the option products have expanded to include mini options tied to 10 shares of stock instead of the standard 100 shares, and weekly options, which expire every Friday, instead of once a month.
In 1982, the listed options market hit a milestone when more than 500,000 contracts were traded in a single day. Options popularity continued to increase with more than 3.8 billion equity options traded last year, with an average of 16.9 million contracts traded each day across a dozen exchanges.