By Brian Burns, author of Trading Stock OptionsPerhaps you are familiar with stock options, or have even traded them, but did you ever wonder how options came about in the first place? Do you know why were they invented and who used them? You may or may not know that an option is a derivative. A derivative is anything that derives its value from an underlying asset. In the case of stock options, the stock is the underlying asset. Options come in two flavors: calls and puts. Calls give the option buyer the right, but not the obligation, to purchase the underlying stock at a specified price, known as the strike price. Puts give the option buyer the right, but not the obligation, to sell the underlying stock at a specified price. Both types of option contracts are subject to expiration and can expire worthless. The option contract's length of time, also known as the expiration date, is agreed upon at the time of purchase. Calls can only be exercised when the underlying stock is above the agreed upon strike price. Puts can only be exercised when the underlying stock is below the agreed upon strike price. During the life of the contract, options can be bought and sold through most online brokers. It's no doubt that options are growing in popularity. Most brokers now offer free option-trading tools, and the commission rates to trade options have continually been on the decline. But when did option trading first originate? Most option historians point to two main examples of how options were first used: Thales the Milesian and the tulip bulb bubble of 1637.
Aristotle mentions Thales in Politics. The consensus is that Politics was written around 350 B.C. Thales is mentioned briefly in one of the sections in which Aristotle describes how useful it is to achieve a monopoly in any facet of business. The story is that Thales, an avid philosopher and astrologist, predicted that the next year's olive harvest would be more bountiful than usual. Once the olives were harvested they would then need to be processed using olive presses. Thales' prediction of a great olive harvest meant that the right to use the olive presses would be selling for a higher rate than the rate for a typical olive harvest. So how did Thales capitalize on his insight? Being that it was the off-season, Thales approached the owners of the presses and asked them to sell him the right to use the olive presses during the harvest season. Thales agreed to give the owners of the olive presses a small premium immediately, which the owners would keep either way, in order to lock in the right to use the presses for the next harvest at an agreed upon price. The owners didn't mind doing this as they would get a guaranteed amount either way, and if Thales walked away from the deal, they would still be able to sell the rights to use the presses as they typically do each year. In the end, Thales ended up being right; he was able to sell his rights to use the presses for a huge profit.
One of the most notable uses of option contracts in history occurred during the tulip bulb bubble of 1637. I know what you might be thinking, a bubble over a flower? Not only was there a bubble over a flower but its collapse was significant enough to adversely affect the economy of the Netherlands for years after the event. During the 1630s, tulip bulbs in Holland began to appreciate in value. In what was similar to the dot-com bubble of the late 1990s and early 2000s, people began to chase the price of tulip bulbs up to levels that were not only unsustainable but would have dangerous ramifications for individuals, as well as nations, once the tulip bulb fad wilted. Options and futures became popular derivatives during this time for a couple of reasons: delayed delivery and leverage. Tulip dealers would plant bulbs which would not be ready for delivery or sale until sometime in the future. This created the perfect market for futures and options as the buyers, speculating that the price of bulbs in the future would be higher than when they were planted, would enter into call contracts to purchase the bulbs at a specified price and at a future date in time. For this right, they would pay the seller of the bulb a premium which the seller would keep regardless of the price of the bulb in the future. Most speculators at this time would have used options because of the leverage. For a small amount of money, the premium, these speculators could enter into dozens, if not hundreds, of contracts in the hopes of selling those contracts later at a much higher price. The use of leverage helped inflate the prices of the bulbs as more and more people began speculating under the greater fool theory.
As it turned out, the prices of the bulbs completely collapsed. Since the options and futures markets were not regulated as they are today, many of the buyers and sellers of the contracts walked away from their obligations. Barings Bank was founded in 1762 and, at the time of its collapse in 1995, was the oldest bank in England. The bank was solid enough to survive not only the Napoleonic Wars, but both World Wars. Despite this strength, the bank was brought down by a different type of catastrophe -- one named Nick Leeson. Nick Leeson was assigned to be the manager of the bank's derivative operations in Singapore in 1992. A typical trading strategy that Leeson was supposed to be employing is an arbitrage strategy between the Singapore Stock Exchange and the Japanese Stock Exchange. For example, a trader could sell an option to open a position on one exchange and then buy the same type of option on the other exchange with the goal of profiting from the price discrepancies between the two exchanges. This would be a low-risk, low-reward type of strategy but, if employed numerous times and managed effectively, it could still be quite profitable. Leeson wasn't always hedging his options positions, however, and began to incur huge losses from his trading mistakes. Because of an internal standard oversight, Leeson was able to hide the losses from his superiors in England, at least for awhile. His undoing came about because of the Kobe earthquake in Japan on Jan. 14, 1995. The large drop in the Nikkei after the earthquake caused Leeson's options trading losses to hemorrhage. Barings Bank was declared insolvent on Feb. 26, 1995. The losses that Leeson incurred were estimated at around $1.3 billion.
While options have been traded throughout U.S. history, stock option trading at today's volumes and by the individual investor is a relatively recent phenomenon. Most of the option trading prior to 1973 had been done by farmers and businesses seeking to hedge their agricultural exposure. Options were used in order to lock in prices for both selling and purchasing crops. One of the most important changes to the stock option market in the U.S. States is known as standardization. Before 1973, option buyers made individual contract agreements with option sellers. This made the option market highly illiquid as the terms for each contract might be different. Once stock options were standardized, it meant that 1 contract = 100 shares of stock (although there are exceptions). In addition to the size of the contract, the expiration date and strike price were also standardized. In 1973, the Chicago Board Options Exchange (CBOE) became the first U.S. exchange to trade listed stock options. The CBOE offered call-option trading on 16 different stocks. Before this, there was no exchange set up to match buyers and sellers of option contracts. In 1975, the Securities and Exchange Commission enabled the Options Clearing Corporation (OCC) to serve as the central clearinghouse for all exchange-traded options. This was a crucial improvement to the options market as it helped ensure the validity and liquidity of the market. The OCC acts as the guarantor, and its job is to make sure that all obligations of the option contracts bought and sold are fulfilled. The OCC operates under the jurisdiction of the SEC.
In 1977, the SEC allowed the trading of put options. In the same year the SEC also placed a moratorium on additional listings of options to evaluate the growth and risk of the option industry. This moratorium was lifted in 1980 which paved the way for option trading on more stocks. In 1982, the OCC had an average daily options contract volume of 500,000 contracts per day. In 2008, the OCC had a record of 30,006,663 option contracts traded in a single day. The birth of the Internet, and the rise of the online brokers, has given the individual investor the tools to trade stock options like never before. Most online brokers offer free trading tools that in the past would have cost thousands of dollars. In addition, the commissions to trade options have never been lower. These factors have lead to the recent growth in the popularity of trading stock options, which by all accounts, appear to be here to stay.