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The Options Trading Body of Knowledge: Market Overview

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With today’s Internet access and widespread discount brokerage services, virtually anyone with an online hook-up can track the markets and trade options. Michael C. Thomsett explains the basics of Options, including their history and common Options terms.
This chapter is from the book

The realm of options is a highly specialized, intricate, and often-misunderstood market. The reputation of options as high risk is only partially deserved. In fact, you can find option products to suit any investment profile, from very high risk to very conservative. This market has grown tremendously since 1973, when the modern era of options trading officially began. Since that first year when options trading began in the U.S., annual volume has grown from 1.1 million contracts (in 1973) up to over 3 billion (in 2008).1

Today, options are more popular than ever and have become portfolio tools used to enhance profits, diversify, and reduce risks. Only a few years ago, a few insiders and speculators used options, and the mainstream investor did not have access to trading. Most stockbrokers were not equipped to help their customers make options trades in a timely manner, placing the individual investor at a great disadvantage. With today’s Internet access and widespread discount brokerage services, virtually anyone with an online hook-up can track the markets and trade options.

The History of Options Trading

There really is nothing new about options. They can be traced back at least to the mid-fourth century B.C. Aristotle wrote in 350 B.C. in Politics about Thales, a philosopher who anticipated an exceptionally abundant olive harvest in the coming year and put down deposits to tie up all of the local olive presses. When his harvest prediction came true, he was able to rent out the presses at a greatly appreciated rate.2

In this example, the deposits created a contract for future use. When that contract gained value, the option owner (Thales) proved to be a shrewd investor. Options enable traders to leverage relatively small amounts of capital to create future profits or, at least, to accept risks in the hope that those options will become profitable later. This all relies on the movement of prices in the underlying security. Thales relied on supply and demand for olive presses, and the same strategic rule applies today. Options are popularly used to estimate future movement in the prices of stocks or indexes. The concept is the same, and only the product is different.

A similar event occurred in seventeenth century Holland with a much different outcome, when interest in tulips sparked a mania. The tulip had become a symbol of wealth and prestige, and the prices of tulip bulb options went off the charts. By 1637, prices had risen in these options to the point that people were investing their life savings to control options in single tulip bulbs. The craze ended suddenly, and many people lost everything overnight. Banks failed, and a selling panic took the high level of prices down into a fast crash. There is a valuable lesson in this “tulipmania” for everyone trading options today. In an orderly market, prices of stocks and options rise and fall logically. The reasoning is sound because tangible supply and demand factors make sense. In a market craze, prices change quickly and irrationally. In the tulipmania example, there was no rational reason for anyone to invest everything in tulip bulb options—other than the fact that everyone else was doing it, and it seemed that they were getting rich in the process.

The difference between Thales and the Dutch was one of common sense. Thales saw an opportunity and invested with a clear vision of how profits would follow. He was correct, and he made a profit. In the tulipmania example, greed blinded people, and the reckless actions brought about the crash. Symptoms included the rapidly growing prices, expansion of the market, and the failure to realize that the prices were simply too high.

For many decades after the Dutch experience, public sentiment about speculation was unfavorable. Of course, there were numerous examples of market speculation, which never seems to disappear altogether. However, in the U.S., nothing really took place in any form of options trading in the public markets until 1872. That year, a businessman named Russell Sage developed the first modern examples of call and put options. He made money on the venture and bought a seat on the New York Stock Exchange two years later. His career was successful, but was spotted with occasional scandals. In 1869, he was convicted under New York usury laws and was later associated with Jay Gould, an infamous market manipulator. Gould had tried to corner the gold market at one point and later invested in the railroad industry, along with Sage and many others.

The Sage options lacked standardized terms (rules making option features identical in each case), making it difficult to expand the market beyond the initial buyer and seller. Standardized terms in use today include the number of shares of stock each option controls, the day the option will expire, the stock on which an option is being offered, and the stock price pegged to each specific option.

The Sage options started a trend that never ended. These contracts remained largely limited to a few insiders in the exchanges and were traded over the counter (any form of trading when a specific exchange is not involved in the trade). This trading format remained the same, without any reliable trading rules or valuation, until the 1970s.

The Chicago Board of Trade (CBOT) was interested in diversifying the options market as a means for bolstering trading in the larger investment market. CBOT established a new organization in 1973, the Chicago Board Options Exchange (CBOE). On April 26, 1973, CBOE initiated the first options market with guaranteed settlement (ensuring every buyer and seller that the market would promise execution) and standardization of price, expiration, and contract size for all listed call options. The Options Clearing Corporation (OCC) was also created to act as guarantor of all option contracts. (This means that the OCC acts as buyer to each seller and as seller to each buyer, guaranteeing performing on every option contract.) Trading was initially available on 16 listed companies.3

By 1977, when put options trading was first allowed, the market had grown to over 39 million contracts traded (in 1973, only 1.1 million traded). Trading began taking place not only through the CBOE system, but on the American, Pacific, and Philadelphia Exchanges as well. Today, volume is higher than ever before and spread among the CBOE as well as the American, Philadelphia, New York, International, and Boston Exchanges. A breakdown of 2007’s record 2.86 billion contracts traded is provided in Figure 1.1.

Figure 1.1

Figure 1.1 Option contract volume by Exchange, 2007

Source: CBOE 2007 Market Statistics

Growth in the markets over 35 years has been impressive. This is summarized in Figure 1.2.

Figure 1.2

Figure 1.2 Option contract volume by year, 1973–2007

Source: CBOE 2007 Market Statistics

In 1982, a new concept was introduced beyond the use of calls and puts on stocks. Index options were originated by the Kansas City Board of Trade with options on the Value Line stocks. This Value Line Index option was followed in 1983 with CBOE’s introduction of the OEX (comprised of 100 large stocks, all with options on the CBOE), which is now known as the S&P 100 Index. The Chicago Mercantile Exchange introduced S&P 500 futures trading, which began a trend in trading of futures indexes as well as options. In 1976, CBOT began trading in Government National Mortgage Association (GNMA, also known as Ginnie Mae) futures, which was the first interest rate futures product. Many more options and futures indexes have since followed. By 1984, after years of futures trading on agricultural commodities, options were first listed on soybeans. This began an expansion of both options and futures markets. Today, you can write options on futures, which is a form of exponential leverage. A futures option is a derivative on a derivative.

In 1990, the CBOE introduced a new type of options, the long-term equity anticipation securities option, or LEAPS. The LEAPS option is exactly the same as the listed call or put, but its lifespan is much longer. The traditional option lasts only eight months or so at the most before it expires, but the LEAPS option extends out as far as 30 months. This longer-term option makes strategic planning much more interesting and flexible, allowing traders and investors to use the LEAPS option in many ways that are not practical with a shorter-term call or put.

Today’s options market looks much different than the market of a few decades ago. It has expanded and continues to expand every month. You can buy and sell options on stocks, futures, indexes, and even exchange-traded funds (ETFs). In the future, additional forms of expansion will broaden the influence of options into many more markets, with the introduction of new and potentially profitable option tools.

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