Home > Articles > Business & Management > Finance & Investing

The Options Trading Body of Knowledge: Market Overview

  • Print
  • + Share This
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.

  • + Share This
  • 🔖 Save To Your Account

InformIT Promotional Mailings & Special Offers

I would like to receive exclusive offers and hear about products from InformIT and its family of brands. I can unsubscribe at any time.

Overview


Pearson Education, Inc., 221 River Street, Hoboken, New Jersey 07030, (Pearson) presents this site to provide information about products and services that can be purchased through this site.

This privacy notice provides an overview of our commitment to privacy and describes how we collect, protect, use and share personal information collected through this site. Please note that other Pearson websites and online products and services have their own separate privacy policies.

Collection and Use of Information


To conduct business and deliver products and services, Pearson collects and uses personal information in several ways in connection with this site, including:

Questions and Inquiries

For inquiries and questions, we collect the inquiry or question, together with name, contact details (email address, phone number and mailing address) and any other additional information voluntarily submitted to us through a Contact Us form or an email. We use this information to address the inquiry and respond to the question.

Online Store

For orders and purchases placed through our online store on this site, we collect order details, name, institution name and address (if applicable), email address, phone number, shipping and billing addresses, credit/debit card information, shipping options and any instructions. We use this information to complete transactions, fulfill orders, communicate with individuals placing orders or visiting the online store, and for related purposes.

Surveys

Pearson may offer opportunities to provide feedback or participate in surveys, including surveys evaluating Pearson products, services or sites. Participation is voluntary. Pearson collects information requested in the survey questions and uses the information to evaluate, support, maintain and improve products, services or sites, develop new products and services, conduct educational research and for other purposes specified in the survey.

Contests and Drawings

Occasionally, we may sponsor a contest or drawing. Participation is optional. Pearson collects name, contact information and other information specified on the entry form for the contest or drawing to conduct the contest or drawing. Pearson may collect additional personal information from the winners of a contest or drawing in order to award the prize and for tax reporting purposes, as required by law.

Newsletters

If you have elected to receive email newsletters or promotional mailings and special offers but want to unsubscribe, simply email information@informit.com.

Service Announcements

On rare occasions it is necessary to send out a strictly service related announcement. For instance, if our service is temporarily suspended for maintenance we might send users an email. Generally, users may not opt-out of these communications, though they can deactivate their account information. However, these communications are not promotional in nature.

Customer Service

We communicate with users on a regular basis to provide requested services and in regard to issues relating to their account we reply via email or phone in accordance with the users' wishes when a user submits their information through our Contact Us form.

Other Collection and Use of Information


Application and System Logs

Pearson automatically collects log data to help ensure the delivery, availability and security of this site. Log data may include technical information about how a user or visitor connected to this site, such as browser type, type of computer/device, operating system, internet service provider and IP address. We use this information for support purposes and to monitor the health of the site, identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents and appropriately scale computing resources.

Web Analytics

Pearson may use third party web trend analytical services, including Google Analytics, to collect visitor information, such as IP addresses, browser types, referring pages, pages visited and time spent on a particular site. While these analytical services collect and report information on an anonymous basis, they may use cookies to gather web trend information. The information gathered may enable Pearson (but not the third party web trend services) to link information with application and system log data. Pearson uses this information for system administration and to identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents, appropriately scale computing resources and otherwise support and deliver this site and its services.

Cookies and Related Technologies

This site uses cookies and similar technologies to personalize content, measure traffic patterns, control security, track use and access of information on this site, and provide interest-based messages and advertising. Users can manage and block the use of cookies through their browser. Disabling or blocking certain cookies may limit the functionality of this site.

Do Not Track

This site currently does not respond to Do Not Track signals.

Security


Pearson uses appropriate physical, administrative and technical security measures to protect personal information from unauthorized access, use and disclosure.

Children


This site is not directed to children under the age of 13.

Marketing


Pearson may send or direct marketing communications to users, provided that

  • Pearson will not use personal information collected or processed as a K-12 school service provider for the purpose of directed or targeted advertising.
  • Such marketing is consistent with applicable law and Pearson's legal obligations.
  • Pearson will not knowingly direct or send marketing communications to an individual who has expressed a preference not to receive marketing.
  • Where required by applicable law, express or implied consent to marketing exists and has not been withdrawn.

Pearson may provide personal information to a third party service provider on a restricted basis to provide marketing solely on behalf of Pearson or an affiliate or customer for whom Pearson is a service provider. Marketing preferences may be changed at any time.

Correcting/Updating Personal Information


If a user's personally identifiable information changes (such as your postal address or email address), we provide a way to correct or update that user's personal data provided to us. This can be done on the Account page. If a user no longer desires our service and desires to delete his or her account, please contact us at customer-service@informit.com and we will process the deletion of a user's account.

Choice/Opt-out


Users can always make an informed choice as to whether they should proceed with certain services offered by InformIT. If you choose to remove yourself from our mailing list(s) simply visit the following page and uncheck any communication you no longer want to receive: www.informit.com/u.aspx.

Sale of Personal Information


Pearson does not rent or sell personal information in exchange for any payment of money.

While Pearson does not sell personal information, as defined in Nevada law, Nevada residents may email a request for no sale of their personal information to NevadaDesignatedRequest@pearson.com.

Supplemental Privacy Statement for California Residents


California residents should read our Supplemental privacy statement for California residents in conjunction with this Privacy Notice. The Supplemental privacy statement for California residents explains Pearson's commitment to comply with California law and applies to personal information of California residents collected in connection with this site and the Services.

Sharing and Disclosure


Pearson may disclose personal information, as follows:

  • As required by law.
  • With the consent of the individual (or their parent, if the individual is a minor)
  • In response to a subpoena, court order or legal process, to the extent permitted or required by law
  • To protect the security and safety of individuals, data, assets and systems, consistent with applicable law
  • In connection the sale, joint venture or other transfer of some or all of its company or assets, subject to the provisions of this Privacy Notice
  • To investigate or address actual or suspected fraud or other illegal activities
  • To exercise its legal rights, including enforcement of the Terms of Use for this site or another contract
  • To affiliated Pearson companies and other companies and organizations who perform work for Pearson and are obligated to protect the privacy of personal information consistent with this Privacy Notice
  • To a school, organization, company or government agency, where Pearson collects or processes the personal information in a school setting or on behalf of such organization, company or government agency.

Links


This web site contains links to other sites. Please be aware that we are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of each and every web site that collects Personal Information. This privacy statement applies solely to information collected by this web site.

Requests and Contact


Please contact us about this Privacy Notice or if you have any requests or questions relating to the privacy of your personal information.

Changes to this Privacy Notice


We may revise this Privacy Notice through an updated posting. We will identify the effective date of the revision in the posting. Often, updates are made to provide greater clarity or to comply with changes in regulatory requirements. If the updates involve material changes to the collection, protection, use or disclosure of Personal Information, Pearson will provide notice of the change through a conspicuous notice on this site or other appropriate way. Continued use of the site after the effective date of a posted revision evidences acceptance. Please contact us if you have questions or concerns about the Privacy Notice or any objection to any revisions.

Last Update: November 17, 2020