Investment XYZ

Wednesday, August 13, 2014

A Brief History of Options

Options are contracts with conditional obligations.  I will exam here the origins of these two concepts in human civilization, and put the option trading in historical perspective.

The earliest written record of contracts that entailed some insurance was the famous Code of Hammurabi around 1750 BC, developed by Babylonians and used in early Mediterranean shipping - a merchants received a loan to fund the shipment would pay additional premium in exchange for the lender's guarantee to cancel the loan, should the shipment be stolen or lost at sea.  This can be considered as earliest form of a put option.

The other most quoted example related to options is of Thales in Ancient Greek.  According to Aristotle, Thales of Miletus (c. 600 BC, who was the first mathematician to use deductive method for geometry and famed for the Thales Theorems), predicted that the coming season's olive harvest would be larger than usual, thus during off-season, he acquired the right to use some olive presses the following spring.  When spring came and the harvest was larger as he expected, he exercised his options and rented the presses out at a much higher price than he paid for his option, thus made a nice profit to prove a point that a philosopher could actually use his theory to make money.  This can be considered as the earliest form of a call option.

During the peak of Dutch Tulipmania in 1630s, options were widely used and might contribute to the mania itself as well as the misunderstanding of the mania.  For example, in the popular book "Extraordinary Popular Delusions and the Madness of Crowd" by Charles Mackay, Mackay might be confused about the premium of an option and the strike price of an option, and made dramatic claims about the mania that still form the public impression of the first major financial bubble in history.

Option trading started in London in 1700-1733, and was made illegal from 1733-1860, a ban of more than a century due to the public fear of speculation (result of the South Sea Bubble, which Isaac Newton was sucked in, peaked at 1720s).

Russell Sage, a financier who was a friend of the “robber baron” Jay Gould, introduced options to USA in 1872, likely copied the model from London.  The options traded at the times were all so-called OTC (“over-the-counter”) contracts, which the terms were non-standard and negotiated between two parties.

In the first decade of 1900s there were two most important discoveries in option theory: one was the application of “random walk” or “Brownian Motions” theory in option pricing, by the French mathematician Louis Bachelier.  Such method, which revealed the statistical nature of options, or “Volatility”, became the foundation of the modern option pricing theory, and the subsequent the Black-Scholes model.  The second important discovery was the application of call-put parity by multiple option traders and scholars in first few years of 1900s (even though Russell Sage already knew how to use it to create synthetic loan). The call-put parity links option to futures contracts, but more importantly, it dispelled the myth that calls and puts are directly linked to bull bear sentiment.

Until the opening of Chicago Board of Option Exchange (CBOE) in 1973, options are trading on the side market with non-standard or OTC contracts, and were usually associated with shady dealing.  The advance of CBOE (as part of CBOT) brought standardized contracts (“Exchange Listed Options”), introduced transparency and volume into the derivative market.  In some sense, 1973 can be considered as the dawn of modern financials. 

Coincidentally, in the same year, Fischer Black and Myron Scholes published the Black-Scholes model for option pricing.  Undoubtedly, that is the most important milestones not just in options but also in modern financial theory.  It ushered in an era of pricing financial derivatives through a framework of stochastic process (that traced its root to Bachelier).  Such modeling methodology in returns also brought about the flourish of derivative business on Wall Street in the subsequent decades. In 1997, the Nobel Prize in Economics was awarded to Scholes and Robert Merton.

Though call-put parity was known in early 1900s, public generally still averted to puts and even considered it as unpatriotic.  CBOE only introduced put options in 1977, four years after the exchange was opened.  Even when put options were already traded, the aversion to puts continued, leading to the so-called "Portfolio Insurance" in the 1980s, which was basically a trading program to construct market index puts by systematically selling equities.  Such folly was the main origin of 1987 "Black Monday", the biggest one-day percentage stock market crash in history.

When CBOE first opened on April 26, 1973, it traded 911 contracts. Since then, option trading volume has been steadily growing.  Today, each single day the equity option volume is around 15 million contracts. 

The opening of ISE (International Securities Exchange) Option Exchange in 2000 brought the electronic trading to options.  In the subsequent years, we see 3 major trends: 1. All traditional exchanges started bringing electronic execution to the mix, while there are several new option exchanges like BOX, MIAX, emerged to serve electronic trading only; 2. As in stock, bid-offer spreads continue to shrink; 3. More standardized exchange traded options are now available, especially the weekly options.  In 2000, there are about 200,000 distinct listed options available.  Currently there are more than 600,000.

Volatility strategy probably has its root from the days when Black-Scholes formulas was first published.  The collapse of Long Term Capital Management (LTCM), which Scholes and Merton were involved, was in part due to its short 400 million Vega volatility book.  The volatility strategy was actually more well developed in the market making business (rather than hedge fund firms like LTCM), such as O'Conner & Associates (acquired by Swiss Bank in 1989), Hull Trading (acquired by Goldman Sachs in 1999), etc. 

The most well-known index related to volatility is VIX, which is simply a selected average of implied volatilities of near term SPX near the money options.  The index was first proposed in 1989.  CBOE launched the current version of VIX in January 1993.  The calculation was back filled to early 80s using SPX options.  The highest spikes in VIX were 150 in 1987 Crash, and 80 during the 2008 financial crisis.  The interpretation and criticism of VIX are numerous, but after all it is still the most popular index that is associated with volatility.

Although options have a long history tracing back to the dawn of human civilization, the modern option products like the exchange listed options have a relative short history, and in my view, they are the most successful innovation of modern financials.  Consider this: the most active traded equity options today are the SPY options, which take up 15-20% of total equity option volume.  SPY options came only into existence in January 2005.

Derek Wang, CEO, Bell Curve Capital LP. dwang at

Web This Site