Options Trading History

A really short history of options

Nearly every course on options (and even derivatives) begins with the famous story of Thales of Miletus and how he acquired the rights to use the land’s olive presses ahead of a bumper crop. Those interested in revealing the dangers of the financial world will then go on to describe the Tulips fiasco of 17^th Century Holland, and how a counterparty who refuses to honour his/her obligations can pop the bubble – at best. Few mention Josef de la Vega, the contemporary Dutch merchant/poet who wrote the first book ever on stock trading. In it, we found an extremely resonant list of rules:

1. 1. The principal rule in speculation is: Never encourage anybody to purchase or sell shares. Where speculating accurately is a type of black magic, counsel can’t be put on a show.
   2. Accept both your profits and losses. It is best to hold onto what comes to hand when it comes, and not anticipate that your favourable luck and the positive conditions will last.
   3. Profit in the stock market is troll treasure: at one minute, it is carbuncles, the following it is coal; one minute jewels, and the following stones. Here and there, there are the tears that Aurora leaves on the sweet morning’s grass; on different occasions, they are simply tears.
   4. He who wishes to get rich from this game must have both cash and persistence.

Similar as these are to today’s abundance of trading advice providers, Vega also seems to preview today’s more questionable advertising campaigns: “there will be only limited risks to you, while the gain may surpass all your imaginings and hopes,”[1] when describing the thenceforth tulips mania.

Concurrently, Puts and Refusals were becoming popular trading instruments in London at the end of the century – options to buy shares alongside covenants and indentures – different types of contracts. The earliest survival example is a contract made between 2 parties for the delivery of £1000 worth of East India stock by March 1^st, 1688 in return for a 150 guinea (21 shillings – one more than a pound) premium.

19^th Century America saw over-the-counter options thriving – both puts and calls with 3-month expiry dates. These were standardized in the 1970s upon the establishment of the Chicago Board Options Exchange as a guaranteed clearing house to prevent obligation default à-la Amsterdam.

Complexity Not Optional

By this time sufficient history has underlined the risks of options trading and today the average option includes a litany of conditions, including:

• The option’s being the right to buy (CALL) or a sell (PUT)
• Quantity and class of underlying asset.
• Settlement terms – cash or physical exchange of assets.
• Strike price – the stipulated price at which the asset will be bought or sold regardless of its spot price upon expiry.
• The terms by which the premium (the cost) of the option as paid by the option holder to the option writer is determined.
• Expiration date of the option – the last day upon which it can be exercised with the asset changing hands.

In options trading, two transactions are taking place – the future trade of an underlying asset and the present exchange of options. As a result, the four basic types of options trades are:

1. LONG CALLS – the trader expects the value of the underlying asset to increase. He/she therefore BUYS (goes long on) an option to BUY the asset at a strike price he/she hopes will be lower than the spot price (the current market price) when the option expires. Should the spot price be higher than the strike price, the trader does not exercise his/her option.
2. SHORT PUT – the trader still expects the value of the underlying asset to increase. He/she therefore SELLS (goes short on) an option to SELL the asset at a strike price he/she hopes will be higher than the spot price (the current market price) when the option expires. Should the spot price be lower than the strike price, the trader will be obliged to cover the difference.
3. LONG PUT – the trader expects the value of the underlying asset to decrease. He/she therefore BUYS (goes long on) an option to SELL the asset at a strike price he/she hopes will be higher than the spot price (the current market price) when the option expires. Should the spot price be lower than the strike price, the trader does not exercise his/her option
4. SHORT CALL – Again: the trader expects the value of the underlying asset to decrease. He/she therefore SELLS (goes short on) an option to BUY the asset at a strike price he/she hopes will be lower than the spot price (the current market price) when the option expires. Should the spot price be higher than the strike price, the trader will once again be obliged to cover the difference.

When longing an option, the trader pays a premium up front, but then has the option to exercise or disregard the commitment upon expiry. If the strike/spot differential is in his/her favour, he/she will clearly exercise the option and recoup the premium plus a profit. If not, he/she will not exercise the option and have lost the premium.

How does it work?

When shorting the option, the trader will have received a premium up front (often quite a considerable sum, since it is calculated on the potential profit – among other factors) but will have no choice at expiry: he/she will be obliged to pay the strike/spot differential, on one hand, and will lose out on it if in his favour, since his counterparty will obviously not exercise his/her option if it means losing more money (beyond the premium paid).

However, most ‘heavy’ investors do not look upon options as a principal means of investment but rather as a means of hedging their major investments in  physical assets. To do this, they will use sets of options on the same assets employing a fixed set of options strategies. In these, one option cancels out the other vis-à-vis loss in return for placing a ceiling on potential profits.

The four most popular strategies are the Covered Call (selling a call on a longed asset), the Straddle (selling a call and a put at the same strike price), the Strangle (the same but different strike prices)  and the Butterfly Spread.

_______________________________________________________________

[1] Josef de la Vega. Confusion de Confusiones. 1688. Translated by Professor Hermann Kellenbenz. Baker Library, Harvard Graduate School Of Business Administration, Boston, Massachusetts.