Before we delve into the history of options, it would be appropriate to look at the definition of an option.
Definition
Options are not financial instruments in themselves but are a financial derivative whose value is the underlying asset it represents. The option is a contract (an agreement) written by a seller (option writer) to a buyer (option holder), which offers the buyer the right but not the obligation to buy (call option) or sell (put option) a financial asset at a predetermined price (strike price) on a specific date (expiration date) in the future. In return for this right, the option buyer pays a premium to the option writer.
A call option gives the buyer the right to buy an underlying asset in the hope that the price of the underlying asset will go up. The writer (seller) of a call option, however, would want the price to go down so that the option buyer, instead of exercising the option and taking the profits, would let the option expire without exercising it, and the option writer would pocket the premium paid by the option buyer.
A put option is the opposite of a call option in that the buyer would want the underlying asset price to go down. However, the writer of the put option would want the underlying asset price to appreciate so that the option buyer would let the option expire without exercising it, and the option writer would pocket the premium paid by the option buyer.
Don’t worry if you don’t fully understand the concept yet, as a fuller explanation with many examples will be described in later chapters of this book.
You might think that options trading is a fairly newfangled system of investment when compared to other more wellknown ways such as currency trading or buying and selling stocks. The modernday options contracts were introduced in 1973 when the Chicago Board of Options Exchange was founded. However, the very first option to ever be transacted is said to have been in Ancient Greece by a businessman by the name of Thales in the midfourth century BC. Thales successfully created the first option contracts when he paid each owner of an olive press a sum of money to lock his right to use them at harvest time, because he had foreseen that the olive harvest would be the biggest in decades and consequently there would be a huge demand for them. The harvest was as Thales had predicted and he sold his rights to the olive presses to the farmers that needed them and made a large profit.
Although the term option was not in use, Thales had successfully created the first call option by paying for the right but not the obligation to use olive presses at a fixed price and he then exercised his option, gaining a fair profit. Thales had successfully executed a call option using olive presses as the underlying security.
Another important incident in the history of options occurred in the 17th century in Holland at the time of the “tulip bulb mania.” Tulips at that time were immensely popular and the demand for them was increasing at a huge rate. Calls and puts were being extensively used during this period, not for speculation but for hedging purposes. Tulip wholesalers would buy calls to protect themselves from the price going up. Tulip growers would buy puts to protect themselves from the price going down. Contracts for calls and puts were not regulated or as established as they are today.
As the demand for tulip bulbs increased so did the price, and therefore, the value of the options contracts increased also. In addition, a secondary market emerged, which allowed anyone to speculate in the tulip bulb market. The price continued to rise as everyone invested in the market, until eventually the market could not sustain the high prices and the tulip bulb bubble burst and the price fell through the floor. Because the options market was not regulated, there was no authority to force investors to fulfill their obligations and many people lost their life’s savings or their houses and the Dutch economy suffered as it went into recession. At that point in history, options had acquired a really bad reputation; however, they did still appeal to a lot of investors because of the leverage they possessed. Ultimately, they could not overcome their bad name and were banned for 100 years from the 18th to the 19th century.
The next big development in the history of options happened in the late 19th century when a gentleman called Russell Sage started to create call and put options that could be traded over the counter (not through banks or an exchange). He created a lot of activity, which proved to be a noteworthy breakthrough in options trading. He also created formulas that enabled him to establish a relationship between the price of the underlying asset and the price of the option. Unfortunately, he suffered substantial losses and was forced to stop trading but is still attributed to the advancement of options trading.
The trading of options continued through Put and Call Brokers and Dealers who advertised in an attempt to attract buyers and sellers so that the brokers could attempt to match buyers with sellers. Although this was an arduous process, it at least enabled the options market to increase in activity while remaining fairly illiquid. It was at this time that the Put and Calls Brokers and Dealers Association was formed to facilitate the establishment of networks that could help match buyers to sellers and also establish some sort of standards for options. Investors were a lot less wary than previously; however, the lack of regulation did not allow the options market to grow at any significant pace.
Throughout the early 20th century, the options market continued to grow at a slow pace with more people becoming educated in options and their potential uses. However, there was still no pricing structure as such even though the Securities and Exchange Commission had introduced some regulation to the options market. It wasn’t until 1970 that options became fully regulated when the Chicago Board of Trade introduced exchange traded options (1973) and provided a fair transparent marketplace for them to be traded. In addition, the Options Clearing Corporation was formed to establish a centralized clearing process and the proper fulfillment of trades. Also in 1973, two professors, Myron Scholes and Fisher Black, created their Black Scholes Pricing Model, which used a mathematical formula to calculate the price of an option using specific variables. These events made investors far more comfortable in trading options and finally legitimized options, over 2,000 years after Thales.
Today, with the advent of online trading in options, it has become accessible to many more investors, and from a volume of 20,000 traded in 1974, the market has grown to the current volumes of millions traded each day covering thousands of different contracts over many financial assets. Options are extremely popular and show no sign of their growth slowing down.
So there we have it, history lesson is over and welcome to the wonderful world of options! Options are possibly one of the most miscomprehended trading instruments on the financial market today, which is one of the reasons behind this book—to simplify the rhetoric, eliminate the myths, and show you how options are a powerful tool for making money, and reducing risk, if used sensibly. If you understand what they are and how to use them, options are terrific! As we have already mentioned, there has never been a better time for the individual to make money from options.
The reasons for this are as follows:
1. The Internet offers access to realtime data, all the research you could wish for, and more material than you could ever hope to read in a lifetime.
2. Electronic trading has greatly reduced transactions costs.
Options permit through leverage and their limited risk, the ability to customize strategies that exactly align your investment strategies with the market environment, thus enabling you to keep control and retain the odds of profitability in your favor. Each option contract represents a multiple (usually 100) of the underlying asset but costs through its premium a fraction of the price you would pay for purchasing the underlying asset outright. This means that options can give you huge returns on moderately small price movements.