Options are generally defined as a contract between two parties in which one party has the right but not the obligation to buy or sell a specified amount of an underlying security (stock, bond, futures contract, etc.) at a specified price within a specified time.
Ancient history of options
The aged history of options is going way back to Romans and Phoenicians, who used contracts similar to options in shipping. “If they chartered their vessels, Charter Parties were signed, containing terms very similar to today’s, such as the name of the owner, the amount of freight and when it should be paid, the type or types of cargoes to be loaded, the number of days allowed for loading and discharging, the demurrage.
The price of options depends on several factors:
- current price of the underlying security
- strike price of the option
- expiration date
There is also remarkable evidence that Thales of Miletus (624BC-547BC), a Greece mathematician and philosopher used options to secure a low price for olive presses in advance of the harvest. Thales had reason to believe the olive harvest would be particularly strong. During the off-season when demand for olive presses was almost non-existent, he acquired rights-at a very low cost-to use the presses the following spring. Later, when the olive harvest was in full-swing, Thales exercised his option and proceeded to rent the equipment to others at a much higher price. This brought him considerable profit. As Aristotle points out, the scheme has universal application. There need not have been a bumper harvest for the scheme to have been successful.
The concept was formalized in Japan with the first physical futures exchange. To be exact, the house of a wealthy rice merchant named Yodoya, in Osaka, in the year of 1650 is recorded as being the first stationary meeting place for merchants where they would gather to exchange and negotiate their “Rice Tickets.“
There are many other examples of early option trading in the Worlds history: Royal Exchange in London permitted forward contracting, at Yodoya rice market in Osaka, Japan around 1650 were used standardized contracts much like today’s contracts.
History of Chicago Board Option Exchange
In the late 1960s Joseph W. Sullivan, Vice President of Planning for the CBOT, became very interested in the over-the-counter option market. He studied the current practice and concluded that two key ingredients for success were missing. First, Sullivan believed that existing options had too many variables.
Therefore, he proposed standardizing the strike price, expiration, size, and other relevant contract terms. Second, he recommended create a mediator to issue contracts and guarantee settlement and performance. This mediator 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 two-sided markets. 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.
Finally, after four years of careful study and preparation, the Chicago Board of Trade established the Chicago Board Options Exchange (CBOE) and began trading listed call options on April 26, 1973.
The CBOE didn’t get its own place from the beginning. Its first home was actually a smoker’s lounge at the Chicago Board of Trade.
The options trade skyrocket in the first year of existence of CBOE. The first-day volume of 911 contracts became 20,000 contracts as the average daily volume, number of underlying stocks with listed options doubled to 32, exchange membership doubled from 284 to 567 just in one year.
Several changes in the laws made possible to include options in the insurance and banks portfolios. Those important events made options more secure, diverse and popular financial tool. The contacts volume continued to grow.
By the end of 1974, average daily volume exceeded 200,000 contracts. Important to mention, that nation’s newspapers voluntarily began publishing option prices.
It was unusual practice and great accomplishment for CBOE, in view of that the CBOE initially had to purchase news space in The Wall Street Journal in order to publish quotes.
In 1975 the American Stock Exchange, Inc. (Amex) and the Philadelphia Stock Exchange, Inc. (PHLX) begin trading equity options. Both become OCC participant exchanges.
Option Clearing Corporation
Founded in 1973, is the world’s largest equity derivatives clearing organization and equally owned by five participant exchanges that trade options: American Stock Exchange, Chicago Board Options Exchange, International Securities Exchange, Pacific Exchange and the Philadelphia Stock Exchange.
OCC has issued, granted, cleared and settled all transactions that involved listed options on all exchanges.
Exchange-traded stock options have standardized quality: one contract applies for 100 shares of the designated common stock.
OCC established strike price guidance for listed options: for stock with price above $100 options price set at $10 interval.
At the same time there are several other important events helped to promote option trading. First one was introduction of the computerized price reporting. Second, Black-Scholes model was adopted for pricing options. These events revolutionized the investment world in ways no one could imagine at that time. The Black-Scholes model, as it came to be known, set up a mathematical framework that formed the basis for an explosive revolution in the use of options.
In addition, in 1977 SEC allowed to trade put options 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. Nevertheless, annual volume at the CBOE reached 35.4 million in 1979.
Interest to the options trading was growing dramatically and CBOE moved to the new 350,000 square foot building and 45,000 square foot trading floor in 1981. Only 3 years later CBOE outgrow this place and moved to its current location, ten story building next to the Chicago Stock Exchange. In 1983, the Chicago Board Options Exchange decided to create an option on an index of stocks. Though originally known as the CBOE 100 Index, it was soon turned over to Standard and Poor’s and became known as the S&P 100, which remains the most actively traded exchange-listed option.
Option market was continue to grow and by 1985 included NASDAQ stock options and New York Exchange listing of equity options. However, stock market crash in October 1987 made CBOE took different approach to the option trading. To educate investors about options The Options Industry Council was formed along with Option Institute. Long-Term Equity Anticipation Securities was introduced, which are long term dated options that was giving investors more flexibility in using options in their portfolios.
The latest major point in the trading options was the opening by the International Securities Exchange first entirely electronic options market in May 2000.Option Market is still growing and brining more and more investors. In March 2005 CBOE volume increased 15% over March 2004 volume, climbing to a total of 37,826,646 contracts traded.