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CBOE Trading Pit
By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 12, No. 9 on May 8, 2003. 

The 30th anniversary of the Chicago Board Option Exchange (CBOE) occurred on April 26th. In some ways, it seems so short – hard to imagine that 30 years have passed since listed options began trading. In other ways, though, the market has evolved so much since then, that it seems like ancient history. Whichever viewpoint you have (or if both statements seem correct to you, at times), all can agree that the listing of options has been a magnificent success in that it has brought option trading to the masses – with 2.5 or 3 million contracts trading on most days.

Ancient History – The “Old” Over-the-counter Market

In order to have an appreciation for the ease of trading today’s version of listed options, one needs to view it from the historical perspective of longer than 30 years ago. Prior to listed options, all dealings were done through “put-and-call dealers.” An option contract was created – then, as now – when two parties agreed to be buyer and seller. However, the mechanics of that old process were extremely clumsy and basically prevented a secondary market from blossoming. In 1972, for example, if you wanted to buy a call option on IBM, you’d call up your broker (perhaps Merrill Lynch, say) and he’d get in touch with a “put-and-call dealer.” After stating the intention to buy a call on 100 shares of IBM, the put-and-call dealer would try to find a seller for you. He normally kept a list of people who were known to be option sellers and he’d make some calls. You’d have to state what length of time you wanted the option for – usually they were 35, 65, or 95 calendar days, or “six months plus 10 days” or “one year plus 10 days.”

Suppose he found someone who was willing to sell such a call on 100 shares of IBM. He might charge you $825 for the call and give the writer $800, pocketing the $25 difference as his commission. Pricing of the options was generally dictated by some very rudimentary calculations – a general knowledge of the volatility of the underlying stock in question, and a feeling for the supply and demand for the options. The put-and-call dealers were really quite adept at this – much as an experienced option trader might be today, if you asked him to estimate the price of IBM calls for a certain maturity date.

A contract would be signed by the brokerage firms involved (there was actually a physical piece of paper that was exchanged). The seller of the option was considered to be the originator, or writer, of the contract – hence, the seller of an option was (and still is) known as an option writer.

The terms of the contract also needed a striking price, of course. The striking price was typically chosen by quoting the stock as soon as the parties agreed to the option price. So if IBM was trading at 212-5/8 at that time, then that would be the striking price.

At that point, you were the proud owner of a call on 100 shares of IBM, expiring in 35 days, with a striking price of 212-5/8. Not exactly standard terms, but at least you had a leveraged bullish position in IBM.

Now, suppose that IBM rose to 218 in a matter of a week, and you decided you wanted to sell your call and take your profits. Not an easy task to accomplish! Who are you going to sell your call to? If you went back to the “putand- call dealer” and said you wanted to sell your call, he might try to contact the original writer for you. However, the chances that the writer wanted to get out were probably nil. He might have been a covered writer, for example (so, he too is glad to see the stock going up), or perhaps he was bearish and is not willing to give up on his position yet, or there could be any number of other reasons why he would not want to cover.

So, at that point, the “put-and-call dealer” might try to contact another party to see if the person wanted to buy a call on IBM. But now, IBM is at 218, and the call has a striking price of 212-5/8 and expires in 28 days. Not exactly easy to price, is it? So if anyone even bothered to make a bid, it was probably a real low-ball bid – something that you would not even entertain as the call seller.

Thus, your choices would normally be relegated to 1) continue to hold the call and hope IBM can continue to rise, or 2) sell some stock against your call – taking some of the long delta out of the position (in those days, no one used terms like “delta,” but I’m using it here to illustrate the point of reducing one’s long exposure to IBM stock price). Or 3) try to sell some other IBM option to create a hybrid spread of sorts (something we’d call a diagonal spread today – since it’s likely both options would have different striking prices and expiration dates).

Assuming no buyers had been found by the end of that week, your “put-and-call dealer” might even advertise your option for sale in Barron’s Magazine and the New York Times over the weekend. There would be listings of options for sale, and they were all at “odd” terms such as those shown above. Whether this generated much of a secondary market is questionable, but at least people were aware that options were being traded.

The CBOE Changed Everything

The idea of trading listed options originated with some traders on the Chicago Board of Trade (yes, the futures exchange). They thought the standardization of contracts that had made futures trading a success could be adapted to make a liquid market for stock options. They were right. Once the idea was floated, however, it became clear that the regulatory body – the SEC – was not going to allow a futures exchange to begin trading stock options, so the idea of the CBOE was created.

The concept of standardizing expiration dates and striking prices was a revolutionary one. It created the secondary market that we see today. Without this, option trading would still be relegated to low volume because there just wasn’t a convenient way to match a buyer and seller since each option had its own individual characteristics (striking price and expiration date).

Spread trading blossomed, for it was possible to buy or sell another option expiring at the same time, with a slightly different expiration date (or, in the case of calendar spreads, to sell another option with a different expiration date, but the same striking price).

On the first day – April 26, 1973 – there were listed call options only , traded on just 16 stocks (listed puts didn’t start trading on any stocks until 1977). Initially, a full Board of Trade seat included a seat on the CBOE. So futures traders moved back and forth between the two trading floors (the CBOE started out in the old “smoking room” – a very tiny area), if things were dull on the futures exchange. Speaking of seats, the five major put-and-call dealers were all offered seats on the CBOE for $10,000. All declined, save one, thinking the new exchange stood little chance of success. They were wrong, of course, and were soon out of business. In fact, the head of one dealer was actually on the CBOE’s initial advisory board, but never believed in the idea and never bought a seat – eventually watching his put-and-call dealership go down the drain as the CBOE flourished.

Paul Stevens, President of the OIC, estimates that the biggest over-the-counter firm did 300 contracts a week in 1972. Today, he estimates, the listed volume in the first half hour of trading is normally greater than the annual volume of all put-and-call dealers back then.

There was little publicity in the beginning since options weren’t exactly a household trading vehicle (they still aren’t, even today). I heard about the exchange from my broker. The first article that I recall seeing in a major publication was in Business Week about six months after trading began. I don’t think Barron’s even covered the new exchange until quite some time had passed.

The Black-Scholes model (authored by Fisher Black and Myron Scholes, who were both professors at the University of Chicago at the time) was published in 1973 as well (as a coincidence, not as a coordinated effort with the CBOE). It first appeared in something called the Journal of Political Economy! I can’t frankly remember where I first heard about it, but it didn’t seem to gain much publicity until Fisher Black published a more user friendly article in the Financial Analysts’ Journal, in 1975. I do recall being relieved to see that article, in that it verified that some of the things I’d been doing (adjusting for dividends, for example) were actually correct.

The number of stocks on which options were listed expanded quickly; even more so, after the AMEX and the PHLX began trading listed options on their exchanges, in 1975. For a while there was a moratorium on new listings, as regulators tried to control the expansion.

Regulators also introduced something called the “restricted option” in the late 1970's and early 1980's. It was an attempt to protect traders from themselves. In essence, one was not allowed to buy – as an opening transaction – an option that was selling for less that a half a point! That one was passed by Congress. It seems that too many constituents had blown their entire stake by buying deeply out-of-the-money options. Sound familiar? It still happens today, of course, and contributed mightily to the idea that buying options is a bad idea. It is, when the probability of success is ridiculously low, but there’s a lot more to the “story” of buying options than that.

The Expansion and Contraction of the Option Business

Over the years, a number of ideas have been floated, some resulting in the introduction of new contracts – and occasionally some resulting in the delisting of contracts. While the following list may not cover everything, it should give you a flavor as to how the option and derivative “powers that be” are continually looking for ways to expand the market.

It has already been mentioned that put trading began in 1977, but that only included 32 stocks. Eventually, all stocks with listed calls also had listed puts.

Index options were listed in 1983, and “sub-index” options were listed shortly thereafter. We call those sector options, today, and they remain popular. Index futures were introduced as well, and they proved extremely popular, too, in many cases. These products were the first in history to allow individual traders to “trade the market” rather than trading in individual stocks.

LEAPS options were introduced circa 1990 and have proved to be very popular – though they are nothing more than a long-term option.

In the early ‘90's, CAPS options were listed – an option that behaved like a bull spread. These proved to be quite unpopular (although I thought they were intriguing) and they were eventually delisted.

FLEX options were listed – with flexible striking prices and expiration dates – to accommodate the needs of large institutions, who don’t want their options to expire in the middle of the month, but would rather see expiration at the end of the month or quarter (and thus, year).

Futures options began to be traded in the late 1970's – T-Bonds and Eurodollars. Since then, they have expanded to nearly every futures contract as well. In some ways, the later introduction of futures options allowed the futures exchanges to create an improved product – particularly in the area of margin requirements.

An entirely new over-the-counter business arose, in which the major trading firms (Goldman Sachs, Salomon Brothers, Morgan Stanley, Merrill Lynch, etc.) buy and sell massively large options from their institutional customers. These are transactions done off the exchange floor, so they are technically “over-the-counter.” This market, though, owes its existence to the listed market – for the demand would never have been created had not institutional traders seen what benefits could be had from buying puts to protect their stock portfolios against sudden declines, for example.

More recently, the proliferation of exchange traded funds (ETF’s) and the listing of options on them has been the largest new product. There are probably too many of these and they are probably too illiquid, but the thought is a good one. It’s always useful to have a single security available via which to trade an entire sector of the market.

Single stock futures are the latest derivative, although they are not options. So far, they have not enjoyed much success at all. As we predicted initially, this product has limited appeal – mostly as a way to trade stocks on very low margin. In a bear market environment, most people are not looking to do that.

Strategies Over The Years

The mechanics of derivatives trading enabled many strategies to be used. In the beginning – in 1973 – there were only a few strategies utilized by most traders (remember that listed puts did not exist): call buying, bull or bear spreads, and covered call writing. Ratio writes and ratio call spreads were the purview of more sophisticated traders at the time. Arbitrageurs contented themselves with setting up synthetic puts (long calls, short stock) with deeply in-the-money calls so that the interest earned completely covered the time value premium of the call.

With the listing of puts, one of the largest risk-free arbitrage businesses in history commenced: conversion and reversal arbitrage (mostly the latter). Millions of dollars of profits were made, virtually risk-free, from 1977 through about 1984 before competition narrowed spreads so dramatically that profits became miniscule.

To the public customer, the introduction of puts made complete the entire range of strategies – straddles, strangles, and various put spreads. Since then, the strategies have remained the same, but the instruments of implementation have changed and improved.

All this from a small beginning in 16 stocks’ options, traded in a small room thirty years ago. Those 16 stocks, by the way, were AT&T, Atlantic Richfield, Brunswick, Eastman Kodak, Ford, Gulf & Western, Loews, McDonalds, Merck, Northwest Airlines, Pennzoil, Polaroid, Sperry Rand, Texas Instruments, Upjohn, and Xerox (note: no IBM! It was added in the next group of 16, a few months later).

Those next 16 stocks were Avon, Bethlehem Steel, Citicorp, Exxon, Great Western Finl., INA, IBM, Int’l Harvester, IT&T, Kerr-McGee, Kresge, Minnesota Mining & Manufacturing, Monsanto, RCA, Sears, and Weyerhaeuser.

Thanks to Peter Kopple and Paul Stevens for their contributions to this article.



This article was originally published in The Option Strategist Newsletter Volume 12, No. 9 on May 8, 2003.  

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