Stock options and futures are all the rage in today’s investing world. Investors will look at stock futures in the morning to get an educated guess on where the market will go when the markets open. You might decide whether or not to hedge your bets by looking at the price of oil contracts, for example.
The funny thing about stock options and futures is that they sound a lot more complicated than they actually are.
Stock options and futures aren’t some overly complicated investment vehicle created by Wall Street gurus to try to scam their clients. In fact, they trace their origins back thousands of years before Wall Street was even paved.
Today, we’re going to teach you about the surprising history of options contracts, stock options, and futures.
What is a Commodity Futures Contract?
A commodity futures contract allows the holder of the contract to buy or sell a particular quantity of a commodity over a specific time frame for a specific price.
Popular commodities that are heavily traded on futures markets are oil, corn, natural gas, gold, and wheat. Agricultural goods are particularly popular because farmers can hedge their bets and avoid the ups and downs of the market – which can fluctuate wildly for agricultural goods.
The World’s First Commodities Exchange Dates Back to 17th Century Japan
17th century Japan was an interesting place. The nation’s “elite” class, known as samurai, were not paid in yen or any other currency. They were paid in rice.
Understandably, the samurai wanted to protect their income stream. Thus, try tried to control the rice markets. This would allow them to easily convert their rice income into currency they could actually use.
The best way to do this was by creating (and controlling) a market where buyers and sellers could buy and sell rice. That’s exactly what the samurai did. In 1697, Japanese samurai created the Dojima Rice Exchange.
The Dojima Rice Exchange was different from the present Japanese agricultural exchange (known as the Kansai Derivative Exchange). Nevertheless, it laid the foundation for commodities markets that would come centuries later.
Modern Commodities Markets
Today, the majority of commodity markets are managed electronically and modern technology has vastly changed the trading process. Nevertheless, the basic buying and selling process remains similar to the one initially established by the Japanese.
The majority of options and futures pass through a clearing agency called the Options Clearing Corporations (OCC). Options are also available to people all over the world: most of the world’s largest economic countries have futures markets and futures exchanges for all different types of products.
When we say “products”, we don’t just mean commodities like rice and oil. In fact, futures and options can range from commodities to weather, stocks, and pop culture phenomena.
The World’s First Options Were Used in Ancient Greece
Remember up above when I said options trace their roots back thousands of years? These options trace their history back to ancient Greece, which used to speculate on each year’s olive harvest. Options were a way to protect olive growers through bad years when olive prices were down while capitalizing on gains when olive prices were up.
Modern options contracts, however, work in a different way than the ancient Greek options.
Today, as Investopedia.com explains, a stock option gives the holder the right to buy or sell a set number of shares for a pre-determined price over a defined time frame.
Options Trading in the Tulip Mania Crisis of 1636
One of the first major uses of options trading in the modern era occurred in 1636 during an event called Tulip Mania.
That event created a surge in demand that spiked demand of a single commodity – tulips. Tulips soared to record prices. As the surge grew, the first mass trading of options in recorded history was launched.
What’s the big deal with tulips? Well, tulips were seen as a symbol of wealth and affluence. They were only produced in certain regions of the world – like Turkey and Holland. Seemingly overnight, all of the wealthy people in the world wanted tulips in their homes and were willing to pay high prices to get those tulips.
This is where options trading started to take effect. Dutch tulip producers started tulip bulb options trading so that producers could own the rights to owning tulip bulbs in advance and secure a definite buying price. In other words, these growers wanted to grow their tulips knowing that they could earn a certain amount of money by the time the tulips were ready to be sold.
Tulip Mania started in 1636. By February of 1637, the price of tulips had gone so ridiculously high that it was impossible to find sensible buyers. The moment this happened, Tulip Mania turned into a selling frenzy. The price of tulip bulbs quickly collapsed. Options speculators found their options to be worthless.
The Tulip Mania crisis was so bad that the Dutch economy collapsed afterwards. After thousands of traders lost their investments, options trading began to be seen as a notoriously dangerous speculative instrument – a reputation that persists to this day.
Basic Options Trading Between 1700 and 1860 in London
London was the next major city to try its hands at options trading.
At the beginning of the 18th century in London, Put and Call options were given their own organized market. This market was launched with full knowledge of the Tulip Mania debacle. At first, trading was low, as investors wanted to avoid the speculative debacle that happened in Holland.
Despite the low trading volume in London, the practice of options trading was declared illegal by the British government in 1733. That ban lasted more than 120 years until options trading was once again legalized in 1860.
Some, like OptionTradingPedia.com, label London’s ban as “a ban of more than a century due to ignorance and fear.”
Put and Call Options Arrive in the United States in 1872
Starting in 1872, American financier Russell Sage began creating call and put options for US trading.
Sage is credited with creating the first Over the Counter (OTC) options in the United States. These options were totally unregulated and highly illiquid. Nevertheless, Sage made millions through options trading.
Unfortunately for Sage, his fortune disappeared in the market crash of 1884. That crash frightened Sage away from options trading.
Sage was the largest options trader at the time, but he was hardly the only figure. At the turn of the 20th century, options continued to be traded in an unregulated and unstandardized manner. This would ultimately lead to SEC regulation after the Great Depression.
Jesse Livermore, the Stock Option Bookie
The first 20th century American options were launched in bucket shops in the 1920s and were popularized by a guy named Jesse Livermore. Livermore made a living out of predicting the future of the stock market. Instead of owning individual securities, Livermore bet on those securities in an effort to predict their future prices.
Essentially, Livermore was a stock option bookie. When someone came to him and claimed that the stock of, say, P&G was going to go up, Livermore took the opposite side of the trade.
Livermore ended up being a legend on his own and is often called one of the greatest traders in history.
But for the purpose of this article, Livermore’s legacy is that he was the world’s first options trader.
Early Options Markets Were Plagued with Illegal Activities
“Bucket shops”, like the one where Jesse Livermore worked, were similar to modern “boiler rooms”. Both shops would have illegal trading activity at their core. Members of the room would artificially inflate demand for a certain stock despite the lack of earnings or other reasons to invest. Bucket shops hosted some of the earliest pump and dump schemes.
These schemes were significantly easier in the 1920s when people didn’t have the internet at their fingertips. Sometimes, stockbrokers would just make up a company, ask a client to invest, and pocket the money.
In the early days of trading, both commodities futures markets and stock options markets were plagued with illegal activities. Scam artists masquerading as stockbrokers capitalized on the public’s frenzy to buy futures and options.
Today, options markets are as heavily regulated as stock markets. The SEC and, in many cases, the FBI pays close attention to options and futures markets. As outlined in the Commodity Exchange Act, certain futures trading activity is illegal and prohibited. Regulators often struggle to keep up with today’s competitive option and futures markets, where there are rampant reports of price fixing and collusion. Many of these reports stem from the computerized nature of the market, which is why regulators can often face difficulty.
1973: The First Options Start Trading
In 1973, the first options started trading on the brand new Chicago Board Options Exchange (CBOE).
The CBOE was the first options exchange in America. Today, it’s also the largest in the country. The exchange offers options on over 2,000 companies, 22 stock indices, and 140 ETFs.
The very first option was traded on April 26, 1973. That date was deliberately chosen because it was the 125th anniversary of the opening of the Chicago Board of Trade.
All options from the CBOE are cleared through the Options Clearing Corporation, or OCC.
In 1977, the CBOE would introduce put options, which gives us the options trading market that we know today.
By 1999, the total volume of options contracts traded on US exchanges was about 507 million. By 2007, that number had skyrocketed to 3 billion.
Looking back, the most important development of the OCC and CBOE is that they standardized and regulated the options market. No longer were options informal, unregulated, unstandardized, and illiquid. Instead, they were legitimate investment vehicles.
Options were standardized with the same terms across the board. The general public was able to trade call options in a regulated marketplace instead of purchasing OTC options from individuals who were basically bookies. The performance guarantee of the OCC and the liquidity provided by the market maker system spurred market activity.
Prior to the OCC and CBOE, options trading in the United States was hardly more than a trickle of water. After the launch of the OCC and CBOE, options and futures trading grew to a roaring river.
1980: The SEC Gets Involved
The SEC noticed how huge options trading had become. In 1977, the CBOE had increased the number of available options to 43 different stocks while also allowing for puts and calls. In response, the SEC decided to conduct a complete review of all option exchanges.
The SEC put a temporary moratorium on listing options for additional stocks. Then, they discussed whether or not it was a good idea to create a centralized options market.
By 1980, the SEC had come up with a regulatory framework that allowed them to monitor the markets at exchanges while also implementing consumer protection and compliance systems at brokerage houses. Soon after the moralism was listed, the CBOE added 25 more stocks.
4 Advantages of Options
Options have a reputation for being risky investments. But some investors argue that words like “risky” and “dangerous” have been unfairly attached to options – particularly by members of the financial media.
In order to get past the stigma of options and futures trading when they were first introduced, investors had to recognize certain inherent advantages of options trading. Those advantages included:
1) Cost Efficiency
Options give you the ability to benefit from the direction of a stock without actually owning that stock. This can lead to huge cost savings.
If you predict that, say, Apple is worth more than $80 per share, and you decide to purchase 200 shares, then you’d have to pay out $16,000.
With options trading, you have the opportunity to purchase two $20 calls, with each of the two calls/contracts representing 100 shares. This would leave your total cost at $4,000 for the options contracts.
Ultimately, this means you still benefit when Apple stock goes up, but you also have an additional $12,000 to invest wherever you like.
As Investopedia.com explains, “this strategy, known as stock replacement, is not only viable but also practical and cost-efficient.”
2) Less Risk (But Not Always)
Options contracts can be less risky than traditional market activity – although this benefit depends on how you use them.
For example, there are plenty of situations where buying options exposes you to more risk than buying equities. But there are also plenty of situations where you can use options to reduce risk.
Here’s how it works: because options require less financial commitment then equities, they can be less risky. But they’re also less risky because they’re less susceptible to gap openings, which can be catastrophic on your equity values.
But the best way that options help you avoid risk is using “put” options. In traditional equity trading, investors may put a stop order on their $50 stock. If that stock drops down below $45, then the stop order automatically sells that stock on the market. However, if the stock’s value has plummeted overnight, when the market closes, then the stop order will only kick into action when the market opens. Your stop order might be at $45, but you could end up selling at $20 – depending on how badly your stock tanks.
Options, on the other hand, have puts to protect investors. Options trading doesn’t shut down when the market closes. It’s available 24 hours a day, 7 days a week. If you need to get rid of an option, you can do so.
Ultimately, this is why options are the most dependable form of hedging and, some would argue, are safer than stocks.
3) More Efficient Investing
When you spend less money and make similar profit, you’re becoming a more efficient investor. You don’t need a calculator to figure this one out.
4) Multiple Investment Alternatives
Options are flexible investment vehicles that you can use to recreate other positions on the market. Using options for this purpose is called position synthetics.
Synthetic positions let investors attain the same investment goals in different ways. Namely, they let traders capitalize on the passing of time. If the market is remaining stagnant, you can still earn profit by moving strategically.
In the early days, options and futures markets were little understood by brokers. Over time, however, investors discovered the benefits listed above and would eventually make options and futures a critical part of their portfolios.
Ultimately, today’s options and futures markets aren’t some radical invention created in the last few decades. Instead, they trace their roots all the way back to Feudal Japan and ancient Greece. They also owe a lot to early visionaries like Jesse Livermore, who realized you could earn money by betting on the future of the market without actually owning any stocks.
The continued use of markets and futures is a testament to their popularity and utility – even in a totally computerized world. Today, it’s estimated that the market capitalization of derivatives markets exceeds 450 trillion dollars.