The origins of the demand for options were derived from the basic economic desire to secure a lower price for something that would potentially trade for a higher price based upon an individual's knowledge of underlying market factors.
A 25 century old case in point: Thales of Miletus, a Greek philosopher and astrologer, through his skill in reading the stars, had reason to believe there would be an approaching bumper crop of olives in the upcoming season. And seeing as there were plenty of unused olive presses in the off-season, he secured the rights for numerous presses. And seeing as there were no other bidders for olive presses in the middle of the winter, Thales could acquire them with little ado, and also very little money.
When his assumption proved correct and demand for these presses allowed Thales to charge as he liked, at which time he cleaned up in the olive market of ancient Greece selling rights to use olive presses at higher rates that he paid during the off season.
That old example played out again and again through the decades and centuries, leading to Holland in the 1600's and Tulip bulb craze. Tulip dealers used call options to make sure they could secure a reasonable price to meet the ridiculous demand for Tulip bulbs, while Tulip growers used Put options to secure an adequate selling prices for bloated Tulips on the verge of an inevitable tumble.
Human behavior was reflecting a natural tendency toward risk management over specific economic entities, and the use of options as a tool capable of harnessing command over the uncertainty of time and money was no doubt proving to be quite a valuable method for getting the job done.
But there was also an unsettling aspect of options trade, and it was centered squarely on the human element of matters. The damaging results of speculators disavowing what were now their obligations was a real and recurring problem with this vague notion of options trading. In other words, there was a tremendous lack of regulation and standardization that went along with the obvious risk benefits that options could provide, which in turn ultimately led to the unraveling of the Holland tulip bulb craze. There was a pressing need for a fair market.
In America, stock options had existed for almost 200 years by the time the idea of an organized exchange was finally hatched. And in the 1790's, the Buttonwood Agreement was signed, which laid the ground work for what would eventually become the New York Stock Exchange. Wall Street in the year 1785 came up with a catchy suggestion that they quite proudly and eagerly paraded to a public just as eager to hear. It stated:
"If you think stocks are going down, secure a put. If you think stocks are going higher, secure a call." Hence the building blocks and essential backbone of modern options trade were formally created.
But quite possibly the single most important break though in the evolution of options trade came when noted New York Financier and Mathematician Russell Sage began creating synthetic loans using the principle of put/call parity. This equation was derived from Sage's concept of conversion. He found that calls could be changed, i.e. converted, into puts and vice versa, when he established a pricing relationship between option price, the price of the underlying security, and the interest rate. Sage would buy the stock and a put from his customer and sell the customer a call. By fixing the put, call and strike price, Sage was devising a synthetic loan with the arbitrary ability to set the interest rate significantly higher than he normally could.
Still there were questions about the general nature of options in the early years of the 20th century. Although options were infinitely more standardized than in the days before the existence of exchanges, Congress was questioning the excessive number of options that expired worthless. The committee's reasoning was that the public was losing considerable amounts of money from options speculation. Since only 12 ½% of options were exercised, logic followed that 87 ½% of the people who bought options had effectively thrown their money away. Herbert Flier, author of Understanding Put and Call Options, who had been chosen to answer to Congress on behalf of the exchange declared in rebuttal:
" No sir, that money was not thrown away. If you insured your house against fire and it didn't burn down, you would not say you had thrown away your insurance premium." These remarks provided a clearer understanding of the helpful qualities of options. They weren't simply a speculative gadget for those looking for a fresh investment tool, but more a way of stabilizing underlying stock prices and smoothing out and fine tuning portfolios.
As the evolution of options moved onward into the middle part of the 20th century there arose new drawbacks. The presentation of put and call options, along with strategies and their uses had been widely distributed to the business public, but its practical impact was minor. Only 1 in 10,000 investors had a working knowledge of options trading.
The stock options market was controlled by put-call dealers who traded options in the over-the-counter market. These dealers' purpose was to match both parties in an options transaction. They made their living on the spread between what the buyers wanted to pay and what the sellers wanted to receive. Theoretically, there was no limit to the size of the spread. Investors were faced with an often illiquid, almost constantly changing task of turning a profit on seemingly winning options trades. Questions continued to arise about what to expect. Was there a correct price options buyers should pay for an options? What underlying information was involved in determining that price? And most importantly to a beleaguered public - how could buyers be confident they were getting the best price possible?
The complexities of the options market, combined with the inconsistencies of over-the-counter options added to the difficulty of using them at all. It was the late 1960's, and options were being traded in much the same way as they had been for the past 350 years. Its evolution needed one more decidedly bold stroke of blessed progress to truly grow into its own.
Sometimes history is born out of necessity, and other times it develops from chance events and as a default reaction to some other set of circumstances.
In 1968, in the midst of a terrible slump in contracts traded on the CBOT that saw volume and revenues in serious decline, there was a desire to diversify what the exchange offered as trading tools as a way to jump start sagging profits for members and member firms.
But options trade in the securities industry had a less than stellar reputation, with numerous barriers lay between where they presently were on a practical and public-friendly scale and where the needed to be to gain approval from the SEC to create a new options exchange in Chicago. Planners from the CBOT delved into those things that represented drawbacks in the natural evolutionary acceptance of options trading for the common investor. They discovered two essential building blocks for the effective and reliable operation of a fledgling exchange - 1) Standardize the options contract and 2) Guarantee its performance via an intermediary ----- The Options Clearing Corporation (OCC). For decades the over the counter market ruled a game that had the buyer and the seller negotiating through the often arbitrary and inconsistent third party broker/dealer acting as the one ultimately responsible for executing the transaction. In addition, contract prices and expiration dates had no regulation and therefore varied from trade to trade. Standardization would eliminate past problem by reducing the variable to one - the premium.
Once these problems were solved the idea of a fair and balanced marketplace could then be hatched. The natural competition among market-makers on the floor of the exchange which involved trying to give the best bid and offer on specifically designed options gave the public a new found sense of confidence in their ability to initiate a fair trade for a fair price.
The new exchange, called the Chicago Board Options exchange began trading on April 26, 1973, as an SEC "pilot program" with call options on 16 stocks. 911 contracts traded on that first day, but after just a year they were doing 20,000 contracts a day and it was apparent that the CBOE had proved that options trade was in fact a very useful addition to the ways in which financial institutions as well as the public could invest their money.
Still there was the issue of there being no established method of determining what options should be worth. A major influence on the ongoing problem of illiquid spells in trade was the sometimes wide bid ask spread that made options trading, although better than previous over the counter trade, still more expensive than experts thought it could be.
This is where possibly the most influential discovery for options trading was born. Two University of Chicago professors, Fischer Black and Myron Scholes wrote an article for the university's Journal of Political Economy entitled "The Pricing of Options and Corporate Liabilities". These two men came up with the holy grail for options traders and the men who risked their good names and gave the CBOE the benefit of the doubt - a mathematical formula that could derive the price of an option using the concrete underlying variables of time decay, volatility and interest rates. Put options were introduced in 1977 and were quickly embraced as a way to hedge against something most traders tended to foolishly overlook - the idea that you might need protection given a decline in the price of the underlying stock.
What the evolution of options trade on a level playing field did for the investing public was create a means by which the investor had more freedom of choice in shaping the expected return of his portfolio based upon that individual's unique tolerance for risk. Options did not take away from the existing methods of trading stocks, it diffused the potential peril involved with market exposure by offering varied choices of premium selling strategies and spreading opportunities that could only help improve the efficiency and fairness of the stock market itself.
By the early 1980's, options volume had grown exponentially, and was introduced for commodities markets using much the same format as was used for stocks, except for the fact that the market-maker system was adapted to the traditional open-outcry method used at the CBOT for agricultural futures and financial futures. Both treatments have evolved to become major contributing factors the success of the CBOT as we forge ahead into the 21st century.
The technological advancements in computers and communications will certainly feed an options environment that has passed the test of time with flying colors and will undoubtedly continue to evolve further and further towards more efficient and cost effective ways of investing, speculating and managing risk for generations to come.