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Tuesday, April 17, 2012

Copy of a Email: History of Options

A questioner prompted me to look at the history of options. It was fun and here are the snips and pieces from my walk through the internet.

An philosopher called Thales (624-547 BC) may have been one of the first people to get rich by trading options. Thales lived in the Greek city of Miletus, situated on the southwest coast of what is now Turkey. Thales was celebrated for his successful prediction of the solar eclipse which occurred on 28 May in 585 BC, and for his skills in astronomy and navigation. He also became famous for getting rich by speculating in options!

Here's a translation from a passage is taken from Chapter 11, Book 1 of Aristotle's "Politics"

There is an anecdote of Thales the Milesian and his financial device, which involves a principle of universal application, but which is attributable to him on account of his reputation for wisdom. He was reproached for his poverty, which was supposed to show that philosophy was no use. According to the story, he knew by his skill in the stars while it was yet winter that there would be a great harvest of olives in the coming year, so, having little money, he gave deposits for the use of all the olive presses in Chios and Miletus, which he hired at a low price because no one bid against him. When the harvest time came, and many wanted them all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money. Thus, he showed the world that philosophers can easily be rich if they like ...

This was an important turning point as it was the last time in recorded history that a philosopher did something financially useful.

It's known that the Romans and Phoenicians used futures contracts in shipping. Options and futures were traded in Africa over 1000 years before the time of Thales.

Cut to Holland where options on tulip bulbs were traded. Trading in tulip options blossomed during the early 1600s. At first, tulip dealers used call options to make sure they could secure a reasonable price to meet the demand. At the same time, tulip growers used put options to ensure an adequate selling price. However, it wasn't long before speculators joined the mix and traded the options for profit. Unfortunately, when the market crashed dramatically in February 1637 after months of frenzied trading and outrageously high prices, many speculators failed to honor their agreements. The consequences for the economy were devastating. Not surprisingly, the situation in this unregulated market seriously tainted the view most people had of options. After a similar episode in London one hundred years later, options were even declared illegal.

Now this is interesting… the real life unwinding of a derivative market. Maybe Mr. WEB has a reasonable concern… but then we've changed so much since the silly tulip bubble.

In America, options appeared generally around the same time as stocks. In the early 19th Century options were known as "privileges"-were not traded on an exchange. It was up to the buyers and sellers to find each other. This was typically accomplished when firms offered specific contracts on call privileges and put privileges in newspaper ads.

Not unlike what happened in Holland and England, options came under heavy scrutiny after the Great Depression. Although the Investment Act of 1934 legitimized options, it also put trading under the watchful eye of the newly formed Securities and Exchange Commission.

For the next several decades, growth in option trading remained slow. By 1968, annual volume still didn't exceed 300,000 contracts.

For the most part, early over-the-counter options failed to attract a following because they were cumbersome and illiquid. In the absence of an exchange, trading was haphazard to say the least, traders didn't know what other traders had to buy or sell most trading was done by calling around to find out who had what to buy, or sell. To make matters worse, investors had no way of knowing what the real true market price of a given contract was. Instead, the put-call dealer functioned only to try to match up buyer and seller. Operating without a fixed commission, the dealer simply kept the spread between the price paid and the price sold. There was no limit to the wide the spread was. Worse yet, all option contracts had to be exercised in person. If the holder (person who had bought, or owner) of the option somehow missed the 3:15 pm deadline, the option would expire worthless regardless of how deep in-the-money it was.

In the late 1960s, as exchange volume for commodities began to shrink, the Chicago Board of Trade explored opportunities for diversification into the options market. Joseph W. Sullivan, Vice President of Planning for the CBOT, studied the over-the-counter option market and concluded that two key ingredients for success were missing. First, Sullivan believed that existing options had too many variables. To correct this, he proposed standardizing the strike price, expiration date, number of shares in a contract, and other relevant contract terms. Second, Sullivan recommended the creation of an intermediary to issue contracts and guarantee settlement and performance. This intermediary is now known as the Options Clearing Corporation.

To replace the put-call dealers, who served only as intermediaries, the CBOT created a system in which market makers were required to provide a purchase price as well as a sell price (a two-sided market) for all their options. At the same time, the presence of multiple market makers made for a competitive atmosphere in which buyers and sellers alike could be assured of getting the best possible price.

After four years of study and planning, the Chicago Board of Trade established the Chicago Board Options Exchange (CBOE) and began trading, options that were now trade on the exchange were called listed options. The listed options were all standardized with strike prices, expiration dates, size, etc…. The first listed options to be traded were call options, they were written on 16 different stocks on April 26, 1973. This is an event I actually remember. The stock an option is written on became known as the underlying security. The CBOE's first home was actually a smoker's lounge at the Chicago Board of Trade. After achieving first-day volume of 911 contracts, the average daily volume skyrocketed to over 20,000 the following year.

About the same time, new laws opened the door for banks and insurance companies to include options in their portfolios. For these reasons, option volume continued to grow. By the end of 1974, average daily volume exceeded 200,000 contracts. The newfound interest in options also caught the attention of the nation's newspapers, which voluntarily began carrying listed option prices. That's quite an accomplishment considering that the CBOE initially had to purchase news space in The Wall Street Journal in order to publish quotes.

After repeated delays by the SEC, put trading finally began in 1977. I remember this too… and I remember wondering why anyone would trade a put. At first the SEC only permitted puts to be traded on five stocks. Despite the rapid acceptance of puts and the rising interest in options, the SEC imposed a moratorium halting the listing of additional options. Of course, that moratorium was finally lifted and so did the volume on options.

Today, more than ever, option volume and open interest continues to climb. In 1999 alone, option volume at the CBOE doubled. By the end of 1999, the number of open contracts reached almost 60 million.

Starting in 1975, a number of other exchanges began trading listed options. This group included the American Stock Exchange (ASE), the Pacific Stock Exchange (PSE), and what is now known as the Philadelphia Stock Exchange (PHE). The most recent player to enter the game is the International Stock Exchange (ISE). Although the ISE only trades options on a limited number of stocks, the list is literally growing every day. Today, options on all sorts of financial instruments are also traded at the Chicago Mercantile Exchange, the CBOT, and other exchanges.

The derivative market is guaranteed to grow and grow until something occurs to reign it in. The crisis in derivatives is not so much an if as it is a when. C Munger has said that the most important thing to learn from history is that people don't learn from history.
Source: Message Board of Fools.com