From Chris Verhaegh
Let’s take a look at a brief history of options. This is kind of an exciting thing for me to write about. When I began my trading career, only a handful of stocks offered options, with only a smaller handful of strike prices and expirations. The options that were available all expired once a month. Strikes were all five or ten dollars apart. Option prices were in quarters and halves only. There were very few options for trading options.
If you know nothing about options, let me explain to you what they are, how they came to be, and how they function today. If you’re tempted not to read further because you’re already an expert in options trading, read on anyway, you might learn something new.
The first recorded use of options was in 332 BC. Thales of Miletus used his knowledge of stars and weather patterns to predict an unusually large olive harvest for the following year. Since he didn’t have the money to buy up all of the country’s olive presses, he made a deposit to secure the use of all the presses in that region.
Thales was leveraging his money – just like we do with options. He bought the right, but not the obligation, to use the presses at a certain time. An option works the same way. Buying a Call option gives you the right, but not the obligation, to purchase a stock (or other asset) for a certain price by a certain date. Thales leveraged a Call option using the presses as the underlying asset. He must have read his charts correctly, because there was indeed an abundant harvest that year. When the olives started pouring in, instead of exercising his option and running all the presses himself, he sold the rights to use the presses for a sizable profit!
Over the following fifteen hundred years, history only mentions options sporadically – often in the negative light. Probably the most notorious option incident revolved around Holland’s Tulip Mania frenzy in the 1630’s, when the market bubbled so much, the price of a single tulip bulb exceeded the prices of houses! When the tulip bulb bubble burst, many lost fortunes… and options lost credibility to responsible investors and speculators.
Options came to the United States in 1872, when Russell Sage created the first Call and Put options for Wall Street. Option trading remained largely unregulated until a hundred years later, with the formation of the CBOE (Chicago Board of Exchange) and the OCC (Options Clearing Corporation).
Options as we recognize them today were created at that time. The CBOE started listing standardized Call options in 1973 – Puts in 1977. The term “listing” means they started offering them to the public to be bought and sold like stocks. Prior to this time, options were only traded by Put-Call Dealers, who would set their own terms and prices. The problem with this system was, the only person you could sell your options to was the person you bought them from.
The term “standardized” refers to the fact that they created set strike prices and a uniform expiration date. Quick definition: a “strike price” is the target price of the option, or the price at which the option can be exercised. Now, in the past, the strike price was typically the stock’s closing price and the expiration was always about 4 weeks into that future. Every day, the strike price would change, as did the expiration. You would buy an option from the Put-Call Dealer and then you would either exercise it from him, sell it back to him, or let it expire. Your options for trading options were very limited. Options earned a bad rap due to their inherent impediments to the trader’s success.
This all changed in the Seventies, when the options industry as we know it was created. This Moment of Awakening came into being when the Black-Scholes formula – a uniform formula to price options – was developed. One element of this formula solved one of the key dilemmas around pricing options: How do you calculate the decay in an option’s value over time? As you get closer to an option’s expiration, the likelihood of hitting the strike price becomes smaller and smaller, so the option is worth less and less. It seemed obvious, but how to calculate it? The Black-Scholes formula solved that dilemma.
With this formula in place, options were now set to have a uniform (standardized) expiration – the Saturday following the third Friday. While this expiration actually takes place on a Saturday, for all practical purposes it is the third Friday of each month (since none of the exchanges are actually open on Saturday). All stocks with options have their expirations for those options set on the third Friday. Things stayed pretty much the same for almost twenty years. Then in 1990, the first “new” class of options was created. These options acted the same as a Monthly option with one notable exception; they didn’t expire every month, but were designed to be more long-term, as an alternative to stocks. These were named Long-term Equity Anticipation Securities, or “LEAPS” options.
Unlike Monthly options which could expire no further than eight months into the future, LEAPS have expirations nine to twenty-five months into the future. LEAPS always have an expiration on the third Friday of January (well, technically the Saturday following). LEAPS are so consistent with regular Monthly options that when there are only eight months left before expiration, the LEAPS turn into a regular Monthly option. Just under a third of the stocks with options have LEAPS options available.
Fast forward almost another twenty years. Now things really start cooking in the options market.
In July 2006, Quarterly options were started on the five ETF’s. Even now, there are still only ten instruments left in the list. These are mostly ETF’s which can be related to the Futures market in some way. If you want to trade Quarterlies, my recommendation is that you stick with the big guns: Gold is represented by GLD, SPY (known as Spyders) representing the S&P 500, DIA (known as Diamonds) for the Dow Jones Industrial Average, QQQ for the Nasdaq-100 and IWM for the Russell 2000. Due to a lack of liquidity, ignore all the others.
Unlike other options, Quarterly options may expire on any day of the week. They specifically expire on the last trading day of March, June, September and December. You don’t hear much about them, because they really haven’t taken off very well.
In Nov 2006, the CBOE began its pilot program for pricing options in penny increments instead of nickels and dimes. This effectively sped up the movement of option pricing by a factor of five. How so? Let’s say you make twenty dollars an hour at your job. If your boss only pays you in five dollar increments, then you have to work a whole fifteen minutes before the next increment of pay (five dollars) is added on. If, however, he pays you in one dollar increments, then you only have to work three minutes to see another dollar added to your paycheck. Your ability to make money is increased by a time factor of five. Offering option pricing in penny increments versus nickel increments has the same effect for us option traders. It speeds up the time factor of our options. There are currently over 370 stocks and ETF’s that offer penny-wide option pricing.
Then in 2009, the CBOE began experimenting with dollar wide strike prices. This too, had the effect of tightening up the transactional cost of trading the option. Years ago, when options were priced in quarters, a Bid/Ask spread could be $0.75/$1.00. So you had better be certain that your trade was going to make you enough profit to cover that 25 cent transaction cost! If the option happened to be priced in eighths, your spread could have been $0,875/$1.00, cutting your cost in half. When they moved to nickels and dimes, your spread might have been $0.90/$1.00 or better yet, $0.95/$1.00. With penny pricing, your spread can be as small as $0.99/$1.00 making your transactional cost virtually inconsequential to the profitability of your trade.
There are over a hundred stocks that offer one dollar wide strike prices and that number continues to climb. Hopefully, that list will continue to grow.
On June 4, 2010 a new class of options was created: Weeklys. Options with an expiration on every Friday – rather than just the third Friday of the month. And unlike their aged cousin the Monthly option, these actually expire on Friday, not the day after. Also unlike their aged cousins, which may have a lifespan of months or years, Weeklys, as they were initially created, only existed for a few days. They are created on Thursday, eight calendar days prior to expiration.
The creation of Weekly options is the most significant development in option trading for our purposes. My course, book and newsletter would only be academic meanderings without this class of option. The Weeklys program started with about two dozen stocks and has since blossomed into over 200.
In September 2012, the ISE (International Securities Exchange) allowed 50 cent wide strike price intervals on many stocks that have weekly options. It just gets better and better! Our options for trading options keep expanding, giving us more and more opportunities to profit.
Remember I said Weeklys originally existed for only a few days? That was true until November 2012, when options exchanges – due to high demand from investors – expanded their Weekly program from one expiration week to five expiration weeks. Now when you purchase a Weekly option, you can choose an expiration one week, two weeks, three weeks, four weeks or five weeks into the future.
We’ve come a long way in just a few short years. I anticipate this diversification trend will continue and at some time in the future – whether it is two years or ten – option volume and products will grow to the point that they will be offering “Daily” options. That is, options that expire in one day.
If and when they do, so long as I can buy an option late on Friday which will close on Monday, I will be a regular buyer of certain options trying to profit (with leverage) on the certain shock to the world that will take place sooner or later over some weekend after some unexpected news, causing my option to move!