The History of Options Trading

If you are wondering when options trading started, then you have to know that options are not a new financial instrument, and contrary to popular belief, options trading has a long history dating back more than two thousand years.

Options trading has evolved over many centuries, and studying the history of options trading will help options traders appreciate the depth of this popular trading instrument.

Options trading has developed over the course of time to become one of the most flexible, comprehensive, and powerful trading instruments in today’s financial world.

When Did Options Trading Start?

Options trading can be dated back as 332 B.C. (Before Christ), according to Aristotle’s book “Politics.” Aristotle references Thales, a great mathematician, astronomer, philosopher, and one of the seven sages of ancient Greece.

Thales predicted a massive olive production the following year by studying the weather, the sky, and the stars. He anticipated that olive presses would be in great demand after such a huge harvest.

He didn’t have enough money to buy all of the olive presses in the region, but he was able to guarantee the use of all of the olive presses for the following harvesting season with a small deposit. Basically he was the first option buyer in the history of options trading.

So Thales acquired the right to purchase olives prior to harvest, essentially a call option contract with olive presses as the underlying asset. That is how long humans have employed the concept of purchasing the rights to an asset without owning the asset itself.

Thales gained control of the to use the olive presses through a form of option contract, allowing him to either use the presses personally when harvest time arrived (exercising the options) or sell those rights to those willing to pay more for those rights (selling the options for a profit).

As Thales had predicted, the harvest was plentiful, and he made a fortune by selling the rights to use all of these olive presses to anyone who needed them.

The proprietors of the olive presses (the sellers of the options contract), on the other hand, who obviously didn’t know how the harvest would turn out, secured profits by selling “options” to Thales regardless of the harvest results.

Actually, the olive press owners may have been the first humans to adopt a covered call options trading strategy. They held the underlying security (in this case, the olive presses) and sold the rights to use them, keeping the “premium” regardless of whether the presses were ever used.

This procedure established the logic for options and started the long history of options trading.

The History of Options Trading with the Tulip Bulb Mania

During the 1636 tulip bubble, options reappeared in Europe.

This is a classic finance and economics case study in which herding behavior caused a sudden and severe spike in demand, causing the price of a single product, tulips in this case, to skyrocket to absurdly high levels.

Tulip options were commonly purchased in order to speculate on the tulip’s increasing price. This price increase triggered the first mass trading of options in recorded history.

Tulips introduced from Turkey and Holland into Europe swiftly became a status symbol of wealth and beauty in the seventeenth century. Tulips were like fashionable goods that people from all walks of life desired to own back then.

Due to the hype and tremendous demand, tulip prices went up.  As a result, demand for tulip bulbs from growers and merchants surged exponentially, driving up producer prices.

As the price of tulip bulbs rose virtually everyday, Dutch traders, the largest producer of tulip bulbs at the time, began selling tulip bulb options so that producers could acquire the rights to owning tulip bulbs in advance and obtain a definite buying price.

These were tulip bulb call options. What began as a strategy for tulip bulb growers to hedge their risk turned into a speculative fever when the price of the bulbs skyrocketed between the end of 1636 and the beginning of 1637.

The widespread speculative interest in tulip bulb options prompted people from all walks of life to spend everything they had to obtain those options. Some of these people even sold or mortgaged their homes to get the money they needed to buy tulip bulb options.

However, the price of tulip bulbs has risen to the point that it can no longer find suitable buyers. The buying frenzy was quickly followed by a big wave of panic selling.

Tulip bulb prices fell faster than they rose, and practically all option speculators were wiped out as their options fell out of the money and expired worthless.

As a result, the Dutch economy crashed, and individuals lost their savings and even their houses. Because many options speculators were wiped out during the tulip mania, options trading earned a bad reputation as a dangerous speculative instrument.

This is one of the reasons why you should never trade options (or any other risky financial product) with money you can’t afford to lose. Excessive leverage, or investing a big sum of money into a single unhedged call or put options position for the purpose of directional speculation, would be a replay of the tulip frenzy.

The History of Options Trading in London

Despite the option’s bad reputation as a result of the tulip mania, financiers and investors recognized its speculative power due to its inherent leverage.

In the late seventeenth century, a market was established in London, which became the first instance of trading both call and put options on an organized and controlled exchange.

Trading volume was initially limited due to investors’ concerns about the “speculative nature” of options, owing to the relatively recent lessons learned from the tulip mania.

In fact, there was growing hostility to options trading in London, which resulted in options trading being proclaimed illegal in 1733 and being so for more than a century. It was proclaimed lawful again in 1860, ending a century-long ban caused primarily by ignorance and fear.

The History of Options Trading in the United States

Russell Sage, a well-known New York financier, was the first to introduce options trading in the United States in 1872. Russell Sage transitioned from a political career to a financial profession when he purchased a NYSE seat in 1874.

Russell Sage’s version of options trading was a non-standardized and extremely illiquid kind of OTC (Over The Counter) call and put options trading.

That didn’t stop him from generating millions in a matter of years. Russell Sage, on the other hand, lost a fortune in the 1884 market crash, forcing him to abandon options trading entirely. Despite the crisis, Russel Sage died in 1906 with a fortune of almost $70 million.

Even when Russell Sage stopped trading options, the OTC options trading industry he founded continued to operate without him. Options continued to trade unregulated until the SEC was established following the Great Depression.

In fact, following the 1929 stock market crisis, Congress opted to intervene in the financial market. They established the Securities and Exchange Commission (SEC), which became the governing body under the Securities and Exchange Act of 1934.

The Chicago Board of Trade (CBOT) was awarded a license to register as a national securities exchange in 1935, shortly after the SEC began regulating the over-the-counter options market.

Low activity in the commodity futures market pushed the CBOT to explore for new methods to increase its business in 1968. It was planned to establish an open exchange for stock options, similar to how futures contracts were traded.

So, almost 100 years after Russell Sage introduced options trading to the US market, the most significant event in contemporary options trading history occurred. The Chicago Board of Options Exchange (CBOE) and the Options Clearing Corporation  (OCC) were formed off from the CBOT in 1973.

The beginning of options trading as we know it now coincides with the foundation of the CBOE and OCC, which offered standardized exchange traded call options. Unlike the over-the-counter options market, which had no specified contract parameters, this new exchange created detailed standards to regulate contract size, strike price, and expiration date, as well as centralized clearing.

The introduction of these organizations marks a watershed moment in the history of options trading, defining how options are traded on a public exchange today.

The CBOE also introduced put options in 1977, and since then, options trading has taken on the standardized exchange traded form that we are accustomed with.

The CBOE’s most essential role is the standardization of publicly traded stock options. Options were traded over the counter prior to the founding of the CBOE and were largely unstandardized, resulting in an illiquid and inefficient options trading market.

In order for options to be openly traded, all option contracts had to be standardized with the same terms across the board.¬† For the first time, the general public was permitted to trade call options while benefiting from the OCC’s performance guarantee and the liquidity offered by the market maker system.

This is the structure that is still in use today. Since then, more options exchanges have been established, and improved computational models for option pricing have been devised.

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