Happy 40th Birthday, CBOE

By Lawrence G. McMillan

It’s almost unfathomable to me that it was 40 years ago that listed option trading began on the CBOE: April 26th, 1973.  Many of the people associated with the inception of option trading are still active – or at least alive – today, which makes this a very unique market.   To put things into perspective, time-wise, the CBOE (Chicago Board Options Exchange) was originally a spinoff of the Chicago Board of Trade, and the original trading date was designed to celebrate the 125th anniversary of the Board of Trade.  

Personally, I did not trade that day.  I was working at Bell Labs at the time and didn’t learn that option trading existed until my stock broker, Ron Dilks, informed me of the fact after he read an article in Business Week.  I was immediately interested and delved into research and trading shortly thereafter.

Background

What many younger traders may not realize is that there was an option market prior to the CBOE – the “old” Over-The-Counter (OTC) market (there is still an over-the-counter market today, but it is conducted and populated by sophisticated institutions, trading with major firms such as Goldman Sachs and JP Morgan).  Prior to 1973, all option 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!  To whom were you going to sell your call?  If you went back to the “put-and-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 togive 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 that 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.  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 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).   The other major breakthrough was the creation of the Option Clearing Corporation (OCC).  Even today, I suppose that most traders don’t understand the function of the OCC.  But it is very important; it breaks the direct link between buyer and seller.  So, when you buy an IBM option today, and perhaps later exercise it, you are guaranteed (by the OCC) that you will receive the stock as specified in the terms of your call option contract – even if the person you originally bought the call from is now bankrupt.  This same sort of idea is prevalent for futures exchanges, and is what regulators would like to see happen in the Credit Default Swaps (CDS) market that caused so much pain in the Financial Crisis of 2008.

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

911 contracts traded on the first day – April 26, 1973.  These were all call options, for puts were not introduced until 1977.   By the end of 1973, though, over 1.1 million contracts had traded – a number that astounded many and foreshadowed the eventual success.  Today, about 15 or 16 million contracts trade on an average day, about 60% of which are stock options (the rest are index or ETF options).  This explosive success was probably not envisioned by the original designers, but they laid the groundwork to make it happen.  

Edmund “Eddie” O’Connor – a prominent member of the CBOT – is generally credited with first coming up with the idea for listed options (supposedly over dinner with colleagues in 1969).  The CBOT was anxious for new products since decreased activity and increased regulation were harming the grain futures markets. He and his brother, Billy, were instrumental in promoting the idea, and then setting up clearing and trading firms that were the foundation of listed option trading for years.  Eddie O’Connor supposedly executed the first trade on the CBOE.   Much of the original detail work was done by Joseph Sullivan, the first President of the CBOE.  He fought his way (with O’Connor’s help) through antagonism by cynical CBOT members, around non-believers at most of the major New York brokerage firms, and – perhaps most importantly – through the regulatory hurdles thrown up by the SEC.

Trading first began in a small room (the old “smoking room” of the CBOT).  CBOT members were given a seat on the new exchange, to overcome their objections.  Seats originally sold for $10,000.  The five major OTC put-and-call dealers were all offered seats on the CBOE for $10,000.  All buy one declined, 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.

Today there are options on about 3,500 stocks (more are added all the time) and several hundred indices and ETFs.  Futures option trading followed the CBOE by a few years and continues to expand as well.  The idea has proliferated around the world and in the U.S.  There are 9 current U.S. option exchanges, and many more in foreign countries.

All this from a small beginning in 16 stocks’ options, traded in a small room forty 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.

By the time puts were listed in 1977, there were call options on about 250 stocks, but put trading began on only 32 of those.  Of course, today there are puts and calls on every entity that has listed options.  However, there are only volatility options and futures on a few; perhaps someday every entity will have puts, calls, and volatility options.  

Other notable feats along the way included the creation of the first index options (on $OEX – the CBOE Index, now known as the S&P 100) in 1983, LEAPS options (1990), the CBOE Volatility Index ($VIX) in 1993, FLEX options (1993), the new $VIX (2003), $VIX futures (2004) and VIX options (2006).  All of these were CBOE inventions, quickly mimicked by other exchanges unless blocked legally.

Some other products were less successful, such as  CAPS (essentially bull spreads in one option contract), PERCS, and more recently, Variance futures.

Black-Scholes Model

The foundation of option mathematical calculations is the Black-Scholes model even today, despite some of the frailties that have been noted over the years.

The Black-Scholes model (authored by Fisher Black and Myron Scholes, who were professors at the University of Chicago and M.I.T., respectively, at the time) was published in May 1973 (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 was likely some time in 1974.  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.

Thank you, CBOE

In today’s world, with so many exchanges and products, and cheap electronic trading, it’s easy to forget that this all started within many of our lifetimes – thanks to a visionary band of individuals whose adherents have continued to innovate through the ensuing years. 

Visit the CBOE 40th anniversary webpage for more history, stories and photos.