Issue: April, 2003
Three Decades of Options and the World is A-Changin'
by: Gail Osten
Thirty years ago this month, the securities world revolved on its very sturdy little axis for the first time in years. With a scant 16 listed stock options, the Chicago Board Options Exchange went live, and exchange-traded stock options were born.
Far from the center of the New York securities stronghold, the rough-and-tumble, swaggering grain boys of the Chicago Board of Trade conceived of and spat out listed stock options as an experiment during a time when the futures business needed a boost. It was no easy task, and the regulators made it harder.
In retrospect, one wonders if the Board of Trade would have committed as fully to the uncertain success of options had it been able to predict the record-shattering trading volume that would result from scarce grains and simultaneous increased foreign demand during 1972 and 1973. It was during this period that soybeans rose from the $3 level to an historic high of $12.90 per bushel, thus generating plenty of previously unanticipated fees. The fact is options might never have sprung to mind had the Chicago Board of Trade not been looking for new avenues to supplement revenues. It was a good thing that the leaders of the exchange were not clairvoyant.
Whether options traders have loyalty to an exchange is questionable these days as electronic options platforms spring up around the globe, each with their promise of the newest, best, fastest, cheapest. Nonetheless, it was the CBOE that took the chance and laid the groundwork for what last year amounted to 780 million options traded among the five U.S. options exchanges. In 1973, there were only 1.1 million cleared contracts. Now, on average, three million contracts clear each day, and research firm TowerGroup estimates that options trading will grow at 16 percent annually between 2002-2005.
No one can question the impact that options have had on the opportunity level of individual investors, traders and institutions, and this article serves to chronicle those beginnings and the challenges that lie ahead.
April 26, 1973 – Round ‘Em Up, Bring ‘Em In
It’s Day One for the Chicago Board Options Exchange. The birthing room for the infant products is the former smoking lounge of the Board of Trade, the narrow, windowless little southeast corner of the then 120-year old grains exchange. If options didn’t work, they figured, the real estate could certainly be converted back to the land of cigars, Marlboros and off-color jokes.
With just more than a baker’s dozen companies’ options on the block to start, the formal opening day photograph was lacking a throng of people, and says Tom Stern, today chief financial officer for online option brokerage firm, OptionsXpress, “to make it respectable, we had to round up people from off of the Chicago Board of Trade floor and have them pose in the picture.” An inauspicious start to say the least and, yet, given the political wrangling that went on just to get the go-ahead for trading in options, the opening day felt like a reprieve.
It was an industry whose time had come, but not even those closest to it could realize how successful it would eventually become. Prior to exchange-traded stock options, according to Stern, “the over-the-counter options market was pretty willy nilly. You could call a put and call broker, but the put and call brokers didn’t have any regulatory responsibilities as to how much capital they had. They could write the options for any time they wanted and at any price they wanted. They could charge you a premium for anything they wanted.”
Paul Stevens, now president of the Options Clearing Corporation, the clearing organization for the five U.S. options exchanges and others, in the 1960s was a former put/call dealer in New York. He corroborates Stern’s recollection. “It [OTC options] was a puny business – maybe a dozen or so firms ranged from two-man operations to, rarely, maybe 20 to 25 people on the high side. They were in the business of putting together buyers and sellers of options, but it was very loose. If a Merrill Lynch customer wanted to buy five calls on Chrysler, the guy at Merrill asked for two or three quotes.” Continuous, liquid markets? Not so, says Stevens. “In fact, in those days, in the heyday, we’d transact maybe 300 contracts in one day, and we were the largest put and call dealer. Options today do more business in the first 20 seconds of a trading session than we did in a year back then.”
Thank goodness there was little volume back then. Whether mathematically inclined or not, put and call dealers had no Black-Scholes model with which to price options. They basically quoted blue chip stocks in one way and more volatile stocks in another. “You could pay up to 20 percent for a 95-day call on a high-flying volatile stock,” says Stevens, “and buy a six-month call for 10 percent on a blue chip. It was a fun business, frankly, and we thought we were hot stuff. We made a good living, but not an outrageous living, and then this guy Joe Sullivan shows up, trying to pick everyone’s brains in or around the ’71 era.”
Everyone Was Learning Together
Sullivan, who eventually became the founding president of the Chicago Board Options Exchange, had been the Wall Street Journal’s Capitol Hill reporter. He somehow found his way to the Chicago Board of Trade, began to work as assistant to the President Henry Wilson, and then was charged with researching how the CBOT might go about creating a new options entity. As lofty as the title president sounds, according to staff members at the CBOE during the early years, Sullivan was extremely down to earth and was just trying to figure out how to get the new project done well.
“I remember taking a phone call from the media one day and whatever the question was, it hadn’t been asked before, and I was stumped,” says Joe Marconi, former vice president of public relations for the fledgling exchange. “I wandered by Joe Sullivan’s office and told him about the call, and he asked me to come in so the two of us could figure out an answer together. He was stumped, too, but the open office door made it possible for many of us to figure out things that really were in the formative stages. Anyone and everyone was listened to.” Marconi relates that there was an incredible sense of adventure and pride in working in this new and untried industry, and he recalls the cheers that would emanate from the trading floor when the public address system on an ongoing basis would announce a new volume record for the day.
From the Board of Trade’s spacious floor, traders could view LaSalle Street as far as their vision could stretch. There was some respectability in being more than 100 years old, even if it wasn’t the tony securities business. But the options market was the upstart child, with little standing or earned respectability. Options members were scorned by Wall Street, ignored by the news media and were about to be forced to live through one of the worst bear markets in stock market history. They simply had nothing to guide them but their own vision of the future.
“In fact,” says Marconi, “though the exchange had the advantage of starting the business from scratch, there was a lot of trial and error going on in all areas. Everyone was learning the business together.”
A firm, eventually known as O’Connell and Piper, best described as a risk management firm, over the years was hired by some 40 to 50 trading firms, brokerage firms and banks to provide daily risk reports and advice on options pricing. As a sidebar, they conducted analytical or training seminars to help professionals manage the risk of an options portfolio. Jim Piper recalls, “We had some of our own analytical tools – a lot of which were just formalized in our heads. Options are not linear, and they’re not two-dimensional. If a stock goes up or down, you make or lose money; those are the only things than can affect your wallet. In options, a lot of other things can happen beside the stock going up and down. One day you lose $1 for a certain move, and the next day you lose $5 for the same size move. All of that stuff made it more complicated, and the risk management business became more serious. Firms always had risk control people who watched margin and so on, but once it became more complicated than just counting up the number of contracts you had, it was necessary to have another approach to it.”
As the CBOE became more successful, Chicago Board of Trade members bristled a bit as the child began to upstage its parent. The CBOE was beginning to become “the hottest game in town,” and the CBOT was concerned that the Securities and Exchange Commission would begin poking it nose under the CBOT’s tent.
OptionsXpress’ Stern, then a vice president with Continental Bank, at the time one of the largest lenders to the securities and futures industry, recounts that options began as a pilot program with only calls allowable. Puts did not come until several years later. “The regulators didn’t quite know what to do with this new entity. It really was the first hybrid securities/futures market, and it had little in common with the securities industry.
Remember, futures traders put it together. The creditability that was established came from the fact that the CBOE from the start determined that there would be expirations just like a Board of Trade futures contract. There would be a contract size just like a Board of Trade contract. There would be delivery just like a Board of Trade contract. The clearing function was modeled after the Board of Trade Clearing Corporation.” But, says Stern, “it was a security, so instead of being a CFTC product, it was going to have to be the SEC, and all of the members would have to be registered with the NASD and under SEC scrutiny.” This, according to many, had a bearing on a number of futures firms deciding early on not to become options members – it was a different regulatory scheme that many did not want to endure.
Memberships to the Chicago Board Options Exchange amounted to $10,000, but for a period of time, “traders could get a $100 option call on a $10,000 seat,” said the OCC’s Stevens. “There was a great deal of skepticism in New York, but somebody was whistling through the graveyard saying, ‘if this is successful, where does that leave us?’ I didn’t have courage at the time to pick up and move to Chicago, but others did. It was a terrible time in the equities business, a bear market with nothing to do. The taxi medallions were worth more than a stock exchange membership, literally. So, there were a number of transplanted New Yorkers who came out to get the market going – people who knew something about the stock market and less about the futures market, but were willing to take a flyer on a new concept.”
Piper recalls that options were still a mom-and-pop business before the large banks got involved. “The clearing firms tried to induce people from other careers to come down and buy a seat and come into this trading business. There weren’t enough people that understood what options were or, even if they did have a sense of it, they had the wrong sense.”
Stevens says, “A lot of people who weren’t making much of a living in the over-the-counter stock business in New York came out to give the market a shot. Others who weren’t even cutting it in the puny little put and call options dealer market joined in. For many of these people who took a chance, it became a gold mine.”
Access to trading in the early days was as simple as applying. Stevens had a friend who ventured out from New York and wandered around the CBOE, having the luck to run into Eddie O’Connor, one of the founding fathers and cheerleaders of the exchange. “O’Connor said, ‘Why don’t you buy a seat,’ reached into his pocket and gave the guy a $100 bill or $200 or whatever, and told him where to apply. ‘Go down the hall—there’s a window there, ask for so and so, and get your application and fill it out.’” “It was those types of efforts,” he said, “that’s made the market.”
The Expansionary Phase
For all intents and purposes, the founders of the CBOE may have been the only ones to have faith in this new venture – but only for a while. Trading volume hovered around 1,000 calls a day, and the professional skeptics on Wall Street were already beginning to reevaluate their options. But a year later, volume had increased more than 40-fold, allowing the CBOE to move out of its overcrowded quarters and onto its own trading floor. The listed options business was well on its way to becoming an established industry.
Other exchanges sat up and took notice. In 1975, the American Stock Exchange (Amex) and the Philadelphia Stock Exchange began trading equity options. The Pacific Exchange (PCX) followed in 1976. Puts in 1998 were added to the strategies available to participants. Other exchanges, including the New York Stock Exchange in 1985, followed later, only to eventually cede their options business to existing options exchanges. The International Securities Exchange, the first all-electronic options exchange, jumped into the fray in mid-2000.
Just five years after options made their debut, the SEC was becoming the bone in the throat of the scrappy, young CBOE members who had started it all, as well as other exchanges that jumped on the bandwagon for a piece of the action. The SEC imposed a moratorium on options expansion – a timeout of sorts. There was a fear of options as a general proposition, and the SEC worried greatly about multiple trading. “Everybody thinks that multiple trading of options started two or three years ago, but it started in the ‘70s with a handful of stocks,” remarked Stevens. “The multiple trading could create some real price differentials in different markets, and that caused some real disruption and gave the SEC cause for concern.” They initiated an options study, and the exchanges spent the better part of two years negotiating with the SEC to come up with something reasonable. The SEC was also concerned about the general area of sales practices and felt they needed to be tightened. After all, options had begun at a time when stockbrokers had little to hawk to their customers, and options gave them a new opportunity. However, they may have been ill equipped to explain these new instruments as well as they might, and the SEC felt that the tightening of these practices was essential to a healthy market.
In the early-‘80s, the scramble for options on popular stocks by exchanges began in earnest. At that time, the exchanges basically listed a limited number of different stocks, with some exception, and they were required to have SEC approval to do so. Eventually, the SEC initiated what was called the “allocation plan,” whereby any option exchange could initiate a lottery with the agency’s approval by indicating they wanted to add, say, options on ten more companies. Stock option picks were accomplished in a manner not unlike a football draft.
Conference calls with all the exchanges in attendance were arranged any time one of the exchanges wanted to add new issues. Each exchange would have its list in hand and be able to make picks. If an exchange had been first to pick the last time, it would be last this time. Any one exchange could force the issue, and no one ever sat out of the process.
This rapid expansion, of course, put a great deal of pressure on all exchanges to get their systems up to speed. The options exchanges needed to be on top of their game technically and in terms of automation to handle the many hundreds of thousands of series, considering the number of strike prices, months and puts and calls. Expansion came with costs.
No Good System Goes Unpunished
When the stock market crash of 1987 came around, no systems, even those that had been continuously upgraded, were good enough to forestall the problems that would take their toll. Jim Porter, who headed up First Options, the largest options firm at the time, remembers that period as if it was yesterday. “The situation was so bad that the industry could not provide closing prices on all of the new options series that had to be opened up. The needed capacity blew out all of the registers because they’d never anticipated needing numbers that big, so the computers were spitting out garbage. Who could have anticipated hundred dollar options? There was never room for a hundred dollar options.” At that point, First Options was actually providing closing prices, using a theoretical price, for the Options Clearing Corporation for days until the markets settled down.
Often it takes an event of that magnitude to open windows to advancement. The year 1987 just happened to be one of those watershed incidents that pushed the industry to institute even greater technological capabilities and safeguards.
The Plot Thickens
What once was an options industry fairly free of repetition today reeks of competition. Gone are the days when one exchange could be the sole “owner” of Dell and another the only place to trade IBM. In 1999, U.S. options exchanges accepted settlements with the Justice Department and the SEC over allegations that the exchanges had agreed to block competition through most of the 1990s. In fact, prior to that settlement, the exchanges were already cherry picking particular stock options from other exchanges to trade. Today, the exchanges are free to compete as fiercely as they wish, and compete they do. It makes for an extremely commoditized industry, very unlike the futures markets that have, at least up until recently, pretty much stuck to their own turfs on the product side.
Commoditization, however, may be good for investors as competition often levels the playing field. That is, of course, unless brokerage firms are paid by market-makers at the exchanges to route business to a particular exchange. Earlier this year, now ex-chairman of the SEC, Harvey Pitt, wrote letters to each of the options exchanges, asking for comments on “payment for order flow,” as it is called. It was clear that he was not favorably disposed to it, nor are the exchanges themselves, and each expressed as much in response letters to Pitt. But unless regulatory reform is enacted that nips this practice in the bud, e.g., the relationships between the firms with order flow and the market makers who pay for that order flow, it will be a practice that will continue under the radar screen of even the exchanges. Nothing yet has been set in regulatory stone on this issue, but chances are very good that the coming months will see progress to limit or eliminate these practices. This will create all the more competition between exchanges.
An extremely positive development recently enacted is a linkage between the five options exchanges that will make way for direct access from each market to competing markets. The decision to link the exchanges stemmed from the desire that orders sent to any one exchange receive the best price available, even if that price sits at one of the other four exchanges. Currently, specialists at exchanges are required by the SEC to find the national best bid or offer (NBBO) for a particular stock and, often, specialists will simply match the best price they see in the market and fill the order in-house. Occasionally, however, they would rather take the offer or hit the bid listed on the other exchange. The options linkage, afforded through the Options Clearing Corporation, will make finding and using the best bid or offer possible.
Where Does the Options Business Go from Here?
It’s obvious. Every exchange will have a new mousetrap.
The International Securities Exchange (ISE) already does – it’s totally electronic, and trading volume has begun pouring in, taking market share away from the traditional leaders. In February, the ISE announced that it had become the second largest options exchange. By March, it revised that to indicate that it was now the largest U.S. equity options exchange in February, with equity options market share at 27 percent, versus 19 percent for February 2002 – a jump of 42 percent.
The American Stock Exchange in March announced across-the-board increases in the size limits available for auto-execution in the most actively traded option classes. Orders of up to 250 contracts in the 50 most active options classes and orders of up to 100 contracts in the next 50 most active options classes can be routed to the system both for customer and broker/dealer orders.
The Chicago Board Options Exchange this spring will marry the efficiencies of electronically matched trading with the liquidity, transparency and intellectual capabilities of the trading floor with a Hybrid Trading System. It is being billed as giving more traders in the pit as well as those on the screen the ability to improve prices as well as make bids and offers tighter. Things are getting more and more electronic.
The Pacific Exchange, where electronic trading systems handle about 93 percent of orders and 53 percent of volume, later this year will introduce PCX Plus that will give professionals the ability to make markets remotely. This is intended to attract market makers much less expensively than at other exchanges, and give them the opportunity to make markets from wherever they sit geographically.
And, so it goes. Competition is everywhere, driving costs down, and with that, the question that everyone asks – is cheaper necessarily the most important element in the financial world? Or speed? Or is it product utility, intellect or leadership that counts? Can we have it all?
Even an astute follower of the exchange-traded options markets can’t answer that question. Their public relations people are all too good. How does one balance the apples-and-oranges comparisons between System X, System Y, and System Z, membership costs versus none, internalization versus out-in-the-open market-making, electronic versus floor models, and hybrids in between? It’s like asking a mother which one of her five children she loves best. She’s bound to say that each has many wonderful qualities. Would she like to roll all of the good and diverse qualities into one child? Some days, probably yes. Most days, probably not. An only child can be a terror. So can lack of competition.
In an e-Bay environment, intuitively, many people assume that electronic is the only way to go; after all, if you’re thoroughly modern, isn’t that the logical thought? Still, many others think that the best electronic platform in the world is still a “work in progress” and can’t replace the human intellect that’s necessary for best execution on many types of orders. Others say that the options business is so commoditized that as long as they get the best price, they really don’t care where it’s traded. How many people call their brokers and say, “I want to buy a put in XYZ options on ABC Options Exchange?” Just doesn’t happen.
Again, this article can’t answer these questions. The market itself, as always, will be the final arbiter of where the business flows and which exchanges will thrive while others languor. It’s an option exchange-eat-option exchange world. One hopes that after the meal is done, the individual investor has enough of a choice to benefit from a positive business evolution played on a level playing field. Think of phone systems of past eras. If you were a customer of Ma Bell before the breakup, you were pretty much at the mercy of this mother. Today, there are more telephone systems than one can even name, and their deals, at least initially during the first year, sound mighty handsome. Year two, the fine print finally kicks in. Such could be the case of the options business, but time will tell.
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