History of the Options Market

Options give traders the right but not the obligation to buy or sell underlying assets at a specific price at a predetermined date. Options Trading has matured over the past century and has seen landmark events. Here is a chronicle of the history of options trading and the significant events that have led to its evolution.

Today, financial markets showcase options trading as innovative and new-age financial instruments. A stock option contract offers the holder the right to purchase or sell a particular number of shares for a specific price over a specific time frame.

However, the use of options in financial trading isn’t a new phenomenon. Options have made their presence felt as early as the 4th century BC. This financial derivative has evolved as one of the most sophisticated instruments with a rich history.

Today, options have become indispensable for reducing risks, enhancing profits, and diversifying the portfolio. A few years back, only institutional investors had access to the stock markets, while the mainstream investors stayed away due to the requirement of heavy capital.

However, with the advent of internet-based trading and an automated electronic trading system, options trading is now accessible. Moreover, with the widespread discount offered by brokerage services, almost anyone with an internet connection and fair knowledge of the options market can trade in derivatives.

In this post, I have chronicled the series of events that have led to the development of the modern form of options trading.

350 BC: Thales and the Olive Harvest

One of the earliest references to options trading was seen in a book written by Aristotle, a Greek philosopher in the mid 4th century BC or precisely 350 BCE. The book named “Politics” included how another philosopher, Thales of Miletus, earned massive profits from an olive harvest.1

Thales had immense knowledge in astronomy and mathematics, which he combined with other subjects to build the foundation of options contracts. Thales studied the stars intricately and predicted that there would be a massive olive harvest in his region. He had identified that the olive presses would witness huge demand and profit from his market vision.

However, Thales lacked the funds required to buy all the olive presses. So, in the off-season, he paid a sum of money to each of the olive presses owners to obtain the rights to use them at harvest time.

Thales agreed to pay a small premium to the owners of the olive presses, which the owners would keep to lock in the right to use the presses for the next harvest at the predetermined price. The owners agreed to this as they would get a guaranteed amount. Even if Thales opted out of the deal, they would still be able to sell the rights to use the presses every year.

When the growing season set in, the olive presses saw a harvest much higher than usual. Since the crop is time-sensitive, the farmers acted in desperation to bid up the payment to the olive mill to quickly process their harvest.

Though the terminology wasn’t official, Thales technically created the first call option where olive presses were the underlying security. He had paid out for the right, but not the obligation, to use the olive presses at a fixed price and ‘exercised’ his options. Thales resold his ownership of the olive presses to the ones willing to purchase and made a considerable profit.

So, the olive press owners can be called the first users of a Covered Call options trading strategy. They owned Olive presses, the underlying asset, and sold rights to using them. They kept the “premium” on the sale regardless of the used olive presses. This is a simplistic framework of how calls work today, just that there are commodities and other financial instruments as the underlying security.

1636: The Tulip Mania

While Thales of Milius set up the premise for call options, the first instance of mass options trading was seen in 1636 during a Tulip Mania.2

The Tulip Mania in Europe is a classic case of how a herd mentality can push the asset prices over the roof. The Tulip mania was quite similar to the dot-com bubble of the late 1990s-2000. Investors began to pursue the price of tulips to a level that wasn’t reasonable or sustainable.

In the seventeenth century, imported Tulips from Turkey and Holland symbolized class in Europe. Besides gin, herrings, and cheese, the tulip bulb became the fourth most exported product of the Netherlands by 1636.24. Tulips were like a signature collection of dresses and accessories. Hence an overwhelming demand led to a spurt in tulip prices.

Due to this, there was a rush among tulip growers and dealers, which increased the price exponentially at the producer level. Due to a daily increase in tulip prices, Dutch dealers began trading tulip bulb options so that producers could own the rights to owning tulip bulbs in advance and fix an actual buying price. These can be termed as Call Options on tulip bulbs.

Options and futures markets emerged as popular derivatives during this phase. The delay in delivery and leverage are two of the biggest reasons behind this rise. Tulip harvest took time to mature. The dealers would plant bulbs that wouldn’t be prepared for sale or delivery until a future date.

These factors created the ideal options and futures markets. It led to speculation that the price of bulbs in the future would be higher than when they were planted. The dealers began to enter into call contracts to buy the bulbs at a specified price and at a predetermined time and date. In exchange for this right, they would pay a premium to the seller of the bulb he would keep irrespective of the price of the bulb in the future.

Leverage was the biggest reason why most speculators used options at that time. Instead of a small premium, the speculators could enter into multiple contracts in anticipation of selling the contracts at a considerably higher price in the future.

However, something intended for hedging the producer risk turned into a mode of speculation. The price of tulip bulbs climbed exponentially between the end of 1636 and February 1637. Due to excessive speculation, buyers from all walks of life bought those options even if they had to mortgage their properties to finance them.

These events led to a bubble formation, which eventually burst in February 1637. To hedge the risk of a bad harvest, tulip dealers bought call options, while tulip growers shielded profits with put options.

In the beginning, the options trading in Holland seemed picture-perfect. However, as the price of tulip bulbs continued to surge, the value of the options contracts increased exponentially. Hence, a secondary market emerged for such options contracts among the masses.

Eventually, there was a selling frenzy, and the tulip prices crashed faster than they rose. Most of the speculators who sold put options could not fulfill their obligations. Nearly all the option speculators incurred significant losses. This led to the collapse of the Dutch economy, and many people also became homeless.

Some even consider the Tulip mania as the first economic bubble in history. It’s noteworthy that these options contracts weren’t as developed as the current markets. The options markets then were wholly unregulated and informal. There wasn’t any way to compel investors to fulfill their obligations.

As a result, options trading gained a negative reputation. Thus the worst consequence of the event was that options trading began to be looked at as a highly speculative trade for the next couple of centuries.

16th-18th century: The Beginning of Option Contracts

An options contract offers the right, but not the obligation, to purchase or sell an underlying asset, which could be a commodity or a stock at a specific date later, under predetermined conditions.

In ancient ages, transactions of goods with hidden option features were an integral part of trade and commerce. In the early days, commercial agreements mainly included elements that were a lot like options. These were packed into a semi-structured agreement that the merchant convention governed.

Between the 16th to 18th centuries, exchange trading for forward and option contracts began on the Antwerp bourse.3

Like the Antwerp bourse pictured above, a bourse is a stock market in a non-English-speaking country.

By the mid-17th century, a standardized clearing process in active options trading began on the Amsterdam bourse. There was a vibrant market of derivative contracts In the Amsterdam bourse, whose underlying asset was the Dutch East India Company’s stock. The Dutch East India Company was considered the world’s first initial public offering.

After the Glorious Revolution, stock and options trading slowly moved to London. By the late 17th century, trading in both options and forward contracts emerged as an essential activity in London’s Exchange Alley in England.

However, trading in options contracts remained a specialized activity involving just a small group of traders until the mid-19th century.

1700 to 1860: Options Trading in London

Despite earning a bad name as a highly speculative financial instrument, options continued to appeal to many traders because of the quantum of leverage they offered. This is also one of the reasons why options trading is so popular even today.

Even as options continued to remain highly popular, they faced increased opposition from time to time. Options have faced bans in various parts of the world, such as Japan, Europe, and many American states. Among them, the most notable ban was the one that happened in London, England.

In the late 16th century, London emerged as a significant destination for options trading. Put and Call options had an individual organized market. As the traders were aware of the Tulip Mania debacle and the fear of speculation was still fresh, they chose to keep the volume of options trading low.

Derivative trades were also known as ‘time bargains’, ‘time trades’, or ‘jobbing trades’. Despite an organized market for puts and calls, in 1733, the British Government declared the options trading illegal in London.

The ban, also known as the Sir John Barnard Act of 1733, lasted over 120 years until options trading was legalized again in 1860.4

1872: Sage Introduces Options Trading in the USA

In 1872, a renowned businessman in the United States, Russell Sage, was the first to formally create and introduce call and put options for trading in the US.

Russell Sage, a New York-born politician turned financier, bought a seat on the New York Stock Exchange in 1874.5 Sage created the option when OTC options in the US were unregulated and highly illiquid.

The options that Sage introduced lacked standardization. This means there were no rules to bring uniformity in the features of the options. This made it difficult to rope in more buyers and sellers. Today, standardized terms include the number of shares of stock that each option controls, the expiration date, the premium, and the underlying asset.

The options created by Sage were a trendsetter. The contracts were traded over the counter and restricted to just a few insiders in the exchanges. This trading format continued in the same way until the 1970s without any formal valuation or standardized trading rules.

However, in the market crash of 1984, Russell Sage incurred a massive loss and gave up options trading altogether. Still, the OTC options trading market continued even without him. Options trading continued in an unregulated manner until the Securities and Exchange Commission or SEC came into existence.

1973: Formation of the CBOE and OCC

After the stock market crash of 1929, Congress created the Securities and Exchange Commission (SEC). SEC became the regulating authority under the Securities and Exchange Act of 1934.7

In 1935, the SEC granted the Chicago Board of Trade (CBOT) a license to register as a national securities exchange.8 The commodities futures market saw low trading volume in 1968, which compelled CBOT to seek ways of expanding its business. Replicating the futures trading model, options trading was conducted using an open-outcry exchange for stock options.

The Chicago Board of Trade (CBOT) wanted to diversify the options market to boost trading. In 1973, it established a new organization, the Chicago Board Options Exchange (CBOE).8 Nearly a century after Russel Sage introduced options officially in the US markets, the Chicago Board Options Exchange (CBOE) and the Options Clearing Corporation (OCC) were formed.

The Options Clearing Corporation (OCC) is the largest equity derivatives clearing organization across the globe, which is monitored by the Commodities Futures Trading Commission (CFTC) and the US Securities and Exchange Commission (SEC). The OCC acts as the issuer and the guarantor for options and futures contracts.

So, we can say that 1973 was a milestone in the history of options trading because these institutions have laid a clear framework for the way options are traded over a public exchange even today. On April 26, 1973, the Chicago Board Options Exchange launched the first options market with a guaranteed settlement. This implies that the market promised execution for every buyer and seller.

Initially, trading was only available on 16 listed companies. However, nearly 911 contracts were traded.9 By the end of April, the average daily volume at CBOE surpassed the over-the-counter options market.

The Chicago Board Options Exchange played a significant role in standardizing publicly traded stock options. Before the formation of the CBOE, over-the-counter options trading was highly unstandardized, which led to an inefficient and illiquid options trading market.

With the CBOE standardizing the stock options, traders were finally able to trade call options, and the Options Clearing Corporation or OCC’s performance guaranteed the market maker system’s liquidity.

This is the structure followed even today. In 1982, the OCC recorded an average daily options contract volume of 500,000 contracts per day. The OCC saw a record of 30,006,663 option contracts traded in a single day in 2008.19

1973: Development of the Black Scholes Pricing Model

Another important event in the same year was developing the Black Scholes or the Black-Scholes-Merton options pricing model.20 The model was created in 1973 by Fischer Black, Robert Merton, and Myron Scholes, and most traders regard this method as the best one for calculating the fair price of options. Five input variables are required in the Black-Scholes model: the option’s strike price, the current stock price, the time to expiration, the volatility, and the risk-free rate.

Black and Scholes’ 1973 paper, “The Pricing of Options and Corporate Liabilities,” published in the Journal of Political Economics, introduced the model’s initial equation.10The foundation of the Black-Scholes formula lies in an equation from thermodynamic physics. This equation was used to obtain a theoretical price for financial derivatives with a predetermined expiration date. It became instantly popular in the options marketplace and was adopted as the standard method for evaluating options pricing.

In 1997, Scholes and Merton received the Nobel Prize in economics for their contribution to developing a new derivative pricing model. Unfortunately, Fischer Black died two years before they received the award.

Black-Scholes assumes that the prices of futures contracts or stock options have a lognormal distribution, are highly volatile, and follow the random walk theory. The model uses these assumptions and other critical variables to obtain the price of a European-style call option.

Interestingly, Black Scholes wasn’t the first options pricing model. Vinzenz Bronzin designed the first option valuation model in 1908. Bronzin was a professor of “Political and Commercial Arithmetic” at the Accademia di Commercio e Nautica, Italy, in 1900. In his 1908 German publication, Theorie der Prämiengeschäfte, Bronzin discussed a particular type of options contract, which was popular then.6

He also talked about every aspect of modern options pricing back then in his book. He derived option prices for an illustrative set of distributions, including the Normal. Bronzin’s work, which was way before the Black Scholes model, is nearly a forgotten research for the option pricing theory.

1977: CBOE Introduces Put Options

By June 1974, the average daily volume of CBOE reached more than 20,000 contracts. In 1975, option trading floors opened in the Philadelphia Stock Exchange and American Stock Exchange. This increased competition and unleashed a broader marketplace for option contracts.

By 1977, CBOE also introduced the put options and laid the foundation of the modern options trading landscape.21 Puts give the option buyer the right to sell the underlying stock at a specified price, but not the obligation. Both call and put options contracts have an expiration date and can expire worthlessly. At that time, the market for stock options had grown to more than 39 million contracts traded compared to only 1.1 million sold in 1973.22

More exchanges followed and established an efficient and standard options trading model. They also adopted the Black Scholes models for options pricing. Trading wasn’t just restricted to the CBOE system and happened on the American, Pacific, and Philadelphia Exchanges.

In the same year, the SEC imposed a moratorium on additional listings of options contracts to measure the growth and riskiness of the options industry.

By 1980, the SEC had introduced new regulations about market surveillance at exchanges and consumer protection and compliance systems at brokerage houses. However, both these regulations were lifted in 1980, which paved the way for more stock options. The CBOE added options on 25 more stocks after the restrictions were lifted.

1983- The Launch of Index Options

On March 11, 1983, the next major event was when index options began to trade.10 This development proved critical in helping to fuel the popularity of the options industry. An index option gives the holder the right, but not the obligation, to purchase or sell the value of an underlying index. Such an index can be the S&P 500 index at a predetermined exercise price. This means that an index option would use an index futures contract as its underlying asset most of the time.

These Index option contracts are usually European-style options that are always cash-settled. This means they settle only on the maturity date, and there is no provision for early exercise. The first index options were traded on the CBOE 100 index, later renamed the S&P 100 (OEX). This is probably because the performance of the index mirrored the S&P 500. The S&P 100 (OEX) was immensely popular and became an option contract with one of the enormous volumes and open interest.

Within a month of its first trading, i.e., the American Stock exchange launched options contracts on another index on April 29, 1983. This new index, called the Major Markets Index (MMI), was constructed as the aggregate of the sum of prices of 20 significant stocks. Structurally, this index was quite similar to the Dow Jones Industrial Average.

Four months later, options began trading on the S&P 500 index (SPX). On July 1, 1983, the S&P 500 index traded just 350 contracts on the first day of the trade.11 Trading in SPX options rose steadily within the next few years, but the crash of 1987 was a major gamechanger for the investors.

Today, there are upwards of 50 different index options, and since 1983 more than 1 billion contracts have been traded.

1990- Long-term Equity Anticipation Securities (LEAPS)

In the fall of 1990, the Chicago Board Options Exchange (CBOE) introduced the Long-term Equity Anticipation Securities (LEAPS).12 Long-term equity anticipation securities (LEAPS) are publicly traded options contracts with longer than a year expiration.

It could typically be up to three years from the issue. Functionally, they are pretty similar to other listed options. The only difference here is the longer times until expiration. This particular feature enables investors to take advantage of longer-term trends in the market.

Since then, organized trading in LEAPS has grown substantially on the CBOE in terms of contract scope and trading volume. Today, LEAPS are available on over 2,500 different securities. Originally, LEAPS were derivative instruments only for stocks. However, more recently, equivalent tools for indices have become available.

LEAPS can result in massive returns, but they can also be risky, so traders have to strike the right balance. LEAPS is more for people who believe that the value of the stock will be worth more than the current market price before the options expire.23

1995: The Barings Bank-Nick Leeson Debacle

One of the most unfortunate events in options trading after the Tulip Mania was the collapse of Barings Bank, England, in 1995.

Barings Bank, founded in 1762, was one of the oldest banks in England. The bank operated on a solid foundation and survived the world wars and the Napoleonic Wars. The same bank appointed Nick Leeson as the manager of its derivative operations in its Singapore branch in 1992.14

Barrings Bank

One of the typical tasks of Leeson was to execute arbitrage strategies between the Singapore International Monetary Exchange and the Japanese Nikkei 225 in the Osaka Securities Exchange. The objective was to earn minor profits from buying and selling futures contracts.

However, instead of aiming at profits on a small pricing differential between both the markets, he eyed superlative profits while betting on the rise of the Nikkei. He stopped hedging the option contracts and began to indulge heavily in speculative trading. He gambled over $1 billion in unhedged, unauthorized trades in the process.

By manipulating internal standards, Leeson hid his speculative activities from his superiors in England for some time. However, the Kobe earthquake in Japan between January 14 and 17, 1995, brought his wrongdoings to light. The quake caused the Nikkei to plummet, and Leeson saw a deluge of losses from his unhedged option contracts.

Unfortunately, on February 26, 1995, Barings Bank was declared insolvent. The total losses that Leeson incurred were around $1.3 billion.

In hindsight, experts say that it was a mistake to put the same person in charge of the derivatives trading and clearing desk. In today’s age, such an event would be less likely due to cybersecurity, advanced trading surveillance, and artificial intelligence.

Mid 1990: Internet Trading of Options

In the mid-1990s, internet-based trading made options available to the general public. This was a far cry from the days when traders had to haggle over individual contracts.

From 1989 to 1996, the volume of futures trading on electronic systems more than doubled as it climbed from 7% to 18%.15 The largest organized futures exchanges globally— the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), and London’s LIFFE—use the open outcry trading method.

However, between 1990 and 1997, the US futures exchanges began to decline in the open outcry mode. In 1997, US exchanges clocked in 41% of the trading volume of exchange-traded products, compared to 65% in 1990.

Many new futures and options exchanges emerged abroad during the same period, and trading volume on non-U.S. exchanges grew significantly. These exchanges primarily focused on automated trade execution. An automated trade execution system has three components: computer terminals, a host computer, and a network linking the terminals to the host computer.

Electronic trading has gained momentum with advancements in technology. Globally, exchanges that use electronic systems to trade futures and options rose from 8 in 1990 to about 40 in 1997.

Even exchanges that used open outcry during regular trading hours depended largely on automated systems for after-hours trading. Besides liquidity and efficiency, one of the most significant benefits of electronic trading is facilitating cross-border trading.

In early 1997, the first electronic link between independent exchanges was established. London, Oslo, and Stockholm exchanges enabled 130 members from seven countries to trade derivatives in real-time. Germany, France, and Switzerland adopted a standard trading and clearing platform in the same year.

Electronic trading systems are more straightforward to regulate compared to open outcry trading. Clearing firms can monitor the risk standing of the traders in real-time as the transactions are recorded in detail, and every aspect is made transparent.

When comparing both systems, it is evident that open outcry trading is more effective for highly active contracts, while electronic trading is more about enhancing efficiency and cost-effectiveness. It is worth noting that electronic trading can eliminate many errors resulting in significant cost savings. On the other hand, orders pass through various intermediaries before hitting the trading floor in the open outcry markets, which increases processing time, cost, and chances of errors.

Moreover, electronic trading systems enable practically impossible trades on open outcry. An example of such a trade is trading an asset and a futures contract based on that asset at the same time.

Before the past decade’s technological advancements, options were just the forte of large corporations and institutional investors because opening a trading account required a tremendous amount of capital.

Also, options trading didn’t offer a user-friendly experience. The screens flashed quotes after quotes, and the traders had to do their calculations to understand the pattern. It was genuinely cumbersome, and stock option trading was best suited only for experts.

There was instant fulfillment of options trading, on-demand quotes, and a vast collection of underlying assets with a broad range of strike prices and expiration dates. The computerized trading system made the options market more liquid and viable, leading to many new players.

The International Securities Exchange LLC (ISE) is the first fully electronic options exchange in the United States. After its launch on February 24, 2000, the ISE traded its 25 millionth contract by May 29, 2001.16

In the United States, seven listed options exchanges include Boston Stock Exchange, Chicago Board Options Exchange, International Securities Exchange, Philadelphia Stock Exchange, New York Stock Exchange (NYSE /NYSE Arca), San Francisco’s Pacific Exchange, and American Stock Exchange (Amex).

Except for ISE, all the other exchanges offer a combination of traditional trading floors and electronic systems. The largest of the US options exchanges, CBOE, executed nearly 40% of its trades electronically.15

The Montreal Stock Exchange and the Eurex Exchange are the two other significant options exchanges in Montreal (Canada) and Frankfurt (Germany).

The proliferation of online trading platforms has completely changed the face of options trading and made the execution very simple. Traders can now execute their strategies and conduct trades even in the most volatile situations.

As the financial markets matured, they gave way to Standardized options, which became the most popular product over the next decade. On average, in 2020, over 10 million options contracts were traded daily on more than 3,000 securities, and the market continues to expand. Due to the vast array of resources on the internet, more retail traders are likely to show interest in stock options.

The emergence of Fintech companies has also facilitated more involvement in options trading. These firms offer user-friendly and interactive desktop as well as mobile platforms. In a nutshell, technology has truly simplified the options market for retail traders.

2020: Parabolic Pandemic Options Trading

The COVID-19 boosted options trading at pace with a rise in equities trading. According to the Options Clearing Corporation, in 2020, stock options trading hit a record with nearly 7.47 billion contracts traded. This was 45% more than the previous record in 2018.18

Most of the trading activity occurred in out-of-the-money options approaching expiration. Most of it is day trading, which implies buying in the morning and exiting the position in the afternoon. Most traders indulged in options trading because they didn’t have enough money to purchase equities.

One can buy options for a fraction of the price and earn profits from options that move the same quantum as the underlying stock if they own the stock. Other factors contributing to the increased options trading during the pandemic are zero commissions trades, availability of educational materials, and social media and chat rooms.

History of Options Trading Regulation

In 1860, the Chicago Board of Trade directors undertook to regulate commodity options trading.17 However, there wasn’t a standardized framework for the regulation. The directors of CBOT just alternated between bans and permissions and were always stuck in internal political issues. To make matters worse, there was no self-regulation.

The abuses in commodity options trading escalated in the 1870s, and there was a significant tiff between the anti-option agrarians and pro-option business people and traders. The tensions also led to major political struggles. Though the farmers succeeded in getting the laws in their favor, there wasn’t any clear distinction between the permissible and non-permissible modes of commodity options trading. The grain traders also ignored the rules most of the time.

There was a constant anti-options sentiment that intensified during the Great Depression. The wheat market collapsed from July 19 to 20, 1933, and speculative trading was the primary reason. Congress acted on this and introduced the Commodity Exchange Act of 1936. On June 15, 1936, a ban was imposed on the commodity options trading for all commodities regulated under the Act. The Act also added a criminal clause for any attempts at price manipulation of commodity prices.

However, due to significant developments in the world agricultural markets, the interest in commodity trading resurfaced in 1971. This phase also introduced three new hybrid commodity options- London, naked, and Mocatta. Unfortunately, the fraudulent transactions done by firms like Lloyd Carr & Co in 1978 led to Congress imposing a ban on commodity options trading again.

Regulators today look towards the exchange-traded options/Options Clearing Corporation model for governing new products and regulating the over-the-counter derivatives markets. They focus on creating an efficient and well-established framework for managing counterparty risk and monitoring risky positions.

The Bottom Line

Options Trading has indeed come a long way and taught many valuable lessons. The difference between the olive press trading by Thales and the Tulip Mania of the Dutch was one of the objectives behind trading.

Thales sensed an opportunity and invested with a long-term vision of earning profits, which he did eventually. In tulipmania, people were led by greed and speculative motives, which ultimately led to the crash.

Options have a critical role in judging the behavior of the stock market as well. Experts use put/call ratios to evaluate the overall market sentiment and make the best trading decisions. The large volume of data has offered a new base for deeper sentiment analysis in recent times.

We have advanced options advisory services that allow traders to look at hedging and speculation more closely. Also, the emergence of high-end modeling technology enables analysts to assess changes in option volatilities to judge the trading sentiment.

Electronic trading was the game-changer for Options Trading. It will be interesting to watch out for more developments in the future. Analysts expect that changes from fractional prices to decimals will gain momentum. The story of a program that allows active series trade in penny stocks is also underway, placing options in the same league as cash equities.

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