Investing in Options

Ancient Origins of Options

Although it isn't known exactly when the first option contract traded, it is known that the Romans and Phoenicians used similar contracts in shipping. There is also evidence that Thales, a mathematician and philosopher in ancient Greece used options to secure a low price for olive presses in advance of the harvest. Thales had reason to believe the olive harvest would be particularly strong. During the off-season when demand for olive presses was almost non-existent, he acquired rights-at a very low cost-to use the presses the following spring. Later, when the olive harvest was in full-swing, Thales exercised his option and proceeded to rent the equipment to others at a much higher price.

In Holland, trading in tulip options blossomed during the early 1600s. At first, tulip dealers used call options to make sure they could secure a reasonable price to meet the demand. At the same time, tulip growers used put options to ensure an adequate selling price. However, it wasn't long before speculators joined the mix and traded the options for profit. Unfortunately, when the market crashed, many speculators failed to honor their agreements. The consequences for the economy were devastating. Not surprisingly, the situation in this unregulated market seriously tainted the view most people had of options. After a similar episode in London one hundred years later, options were even declared illegal.

Early Options in America

In America, options appeared on the scene around the same time as stocks. In the early 19th Century, call and put contracts-known as "privileges"-were not traded on an exchange. Because the terms differed for each contract, there wasn't much in the way of a secondary market. Instead, it was up to the buyers and sellers to find each other. This was typically accomplished when firms offered specific calls and puts in newspaper ads.

Not unlike what happened in Holland and England, options came under heavy scrutiny after the Great Depression. Although the Investment Act of 1934 legitimized options, it also put trading under the watchful eye of the newly formed Securities and Exchange Commission (SEC).

For the next several decades, growth in option trading remained slow. By 1968, annual volume still didn't exceed 300,000 contracts.

For the most part, early over-the-counter options failed to attract a following because they were cumbersome and illiquid. In the absence of an exchange, trading was haphazard to say the least, traders didn't know what other traders had to buy or sell most trading was done by calling around to find out who had what to buy, or sell. To make matters worse, investors had no way of knowing what the real true market price of a given contract was. Instead, the put-call dealer functioned only to try to match up buyer and seller. Operating without a fixed commission, the dealer simply kept the spread between the price paid and the price sold. There was no limit to the wide the spread was. Worse yet, all option contracts had to be exercised in person. If the holder (person who had bought, or owner) of the option somehow missed the 3:15 pm deadline, the option would expire worthless regardless of how deep in-the-money it was (its intrinsic value).

Chicago Board of Trade

In the late 1960s, as exchange volume for commodities began to shrink, the Chicago Board of Trade (CBOT) explored opportunities for diversification into the options market. Joseph W. Sullivan, Vice President of Planning for the CBOT, studied the over-the-counter option market and concluded that two key ingredients for success were missing. First, Sullivan believed that existing options had too many variables. To correct this, he proposed standardizing the strike price, expiration date, size (number of shares in a contract), and other relevant contract terms. Second, Sullivan recommended the creation of an intermediary to issue contracts and guarantee settlement and performance. This intermediary is now known as the Options Clearing Corporation.

To replace the put-call dealers, who served only as intermediaries, the CBOT created a system in which market makers were required to provide a purchase price as well as a sell price (a two-sided market) for all their options. At the same time, the presence of multiple market makers made for a competitive atmosphere in which buyers and sellers alike could be assured of getting the best possible price.

Chicago Board Options Exchange

After four years of study and planning, the Chicago Board of Trade established the Chicago Board Options Exchange (CBOE) and began trading, options that were now trade on the exchange were called listed options. The listed options were all standardized with contract terms (strike prices, expiration dates, size, etc.). The first listed options to be traded were call options, they were written on 16 different stocks on April 26, 1973. The stock an option is written on became known as the underlying security. The CBOE's first home was actually a smoker's lounge at the Chicago Board of Trade. After achieving first-day volume of 911 contracts, the average daily volume skyrocketed to over 20,000 the following year. Along the way, the new exchange achieved several important milestones.

As the number of underlying securities (stocks) with listed options doubled to 32, exchange membership doubled from 284 to 567. About the same time, new laws opened the door for banks and insurance companies to include options in their portfolios. For these reasons, option volume continued to grow. By the end of 1974, average daily volume exceeded 200,000 contracts. The new found interest in options also caught the attention of the nation's newspapers, which voluntarily began carrying listed option prices. That's quite an accomplishment considering that the CBOE initially had to purchase news space in The Wall Street Journal in order to publish quotes.

The Emergence of Put Trading
After repeated delays by the SEC, put trading finally began in 1977. Determined to monitor the situation closely, the SEC only permitted puts to be traded on five stocks. Despite the rapid acceptance of puts and the rising interest in options, the SEC imposed a moratorium halting the listing of additional options. Nevertheless, annual volume at the CBOE reached 35.4 million in 1979.

Today, more than ever, option volume and open interest continues to climb. In 1999 alone, option volume at the CBOE doubled. By the end of 1999, the number of open contracts reached almost 60 million.

Other Exchanges Get Into the Game
Starting in 1975, a number of other exchanges began trading listed options. This group included the American Stock Exchange (ASE), the Pacific Stock Exchange (PSE), and what is now known as the Philadelphia Stock Exchange (PHE). The most recent player to enter the game is the International Stock Exchange (ISE). Although the ISE only trades options on a limited number of stocks, the list is literally growing every day. Today, options on all sorts of financial instruments are also traded at the Chicago Mercantile Exchange, the CBOT, and other exchanges.

Employee Stock Options

With the rapid growth in Internet and Biotech companies over the past few years and the enormous wealth created by employee stock options, more and more people are developing an interest in the concept of owning and trading options. Although there are fundamental differences between the options granted to an employee by a company and the listed options traded on the floor of an exchange, there are important similarities.

When a company grants stock options to an employee, it gives that person the right (not obligation) to buy a certain number of shares at a price often well below market value. Although the options granted by a company eventually expire, they are usually good for extended periods (e.g., 10 years). Generally speaking, options issued by a company are not transferable. Therefore, they cannot be sold or traded to a third party. However, if the company is publicly traded, the employee can exercise the options and convert it to stock. This stock can then be sold on the open market.

For example, the person might have options to buy 1,000 shares at an exercise (strike) price of $12 per share when the stock (in the case of a public company) is actually trading at $50. In this case, the person pays $12,000 for stock that is worth $50,000 on the open market. Not a bad deal at all.

Exchange Traded Options

Although there are a variety of different types of listed options (e.g., stock options, index options), this section will focus exclusively on listed stock options.. Once you understand the basic principles, they can easily be applied to the other financial instruments. Exchange-traded stock options (listed), also known as equity (stock) options, differ from those granted to employees by their company in a number of important ways.

First, they typically have shorter-term expiration dates. Options granted by companies are often good for several years. During that period, they can be exercised (converted to stock) at any point. However, employee stock options cannot usually be sold or transferred. In contrast, exchange traded options (with the exception of LEAPS) are generally valid for 9 months or less and can be bought or sold at any time prior to expiration. To many people, it seems odd that exchange-traded options are not issued by the companies (underlying stock) themselves. Instead, they are issued by the Options Clearing Corporation (OCC). By centralizing and standardizing options trading, the OCC has created a more liquid market.

Unless otherwise specified, each option contract controls 100 shares of stock. In simplest terms, an option holder has the right, but not the obligation, to buy or sell a particular stock at a set price (also called strike price or exercise price) on or before the expiration date. (also called assignment or exercise date). For example, the buyer (also called holder or owner) of a Cisco September 65 Call would have the right (not obligation) to buy 100 shares of Cisco Systems (NASDAQ: CSCO) for $65 per share. Likewise, a Cisco September 65 Put gives the buyer the right (not obligation) to sell 100 Shares of CSCO for $65 per share, until expiration of the option in September.