The History of Options Contracts

The most-reported financial instruments that investors are used to hearing about on the business news are stock options and futures. Many serious investors and traders wake up in the morning and sneak a peek at the stock futures to get a sense of where the market will open relative to the previous day's close. Others may look at the price of oil contracts or other commodities to see if money can be made by hedging their bets during the trading day.

You might assume these futures contracts or options markets are another sophisticated financial instrument that Wall Street gurus created for their disingenuous purposes, but you would be incorrect if you did. In fact, options and futures contracts did not originate on Wall Street at all. These instruments trace their roots back hundreds of years—long before they began officially trading in 1973.

Commodity Futures

A futures contract enables the holder to buy or sell a particular quantity of a commodity over a certain time frame for a particular price. Commodities include oil, corn, wheat, natural gas, gold, potash, and many other heavily traded assets. These derivatives are commonly used by a broad range of market participants ranging from Wall Street speculators to farmers who want to ensure consistent profits on their agricultural goods.

The Japanese are credited with creating the first fully functional commodities exchange in the late 17th century. The so-called elite class in Japan at the time was known as the "samurai." During this time frame, the samurai were paid in rice, not yen, for their services. They naturally wanted to control the rice markets, where the bartering and brokering of rice took place. By establishing a formal market in which buyers and sellers would "barter" for rice, the samurai could earn a profit on a more consistent basis. Working closely with other rice brokers, the samurai started the "Dojima Rice Exchange" in 1697.

This system was much different from the present Japanese agricultural exchange, the Kansai Derivative Exchange.

Today's futures markets differ greatly in scope and sophistication from the barter systems first established by the Japanese. As you might suspect, technological advances have made trading options and futures more accessible to the average investor. Most options and futures are executed electronically and go through a clearing agency called the Options Clearing Corporation (OCC).

Another feature of today's options and futures markets is their global reach. Most major countries have futures markets and futures exchanges on products ranging from commodities, weather, stocks, and now even Hollywood movie returns. The futures market, much like the stock market, has global breadth.

The globalization of futures exchanges is not without risk. As we saw during last decade's meltdowns, market psychology and fundamentals turned down with remarkable intensity largely due to derivative securities. If not for government intervention, the outcomes for the stock and futures markets may have been much worse.

Stock Options

The first options were used in ancient Greece to speculate on the olive harvest; however, modern option contracts commonly refer to equities. So what is a stock option, and where did they originate? Simply put, a stock option contract 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 appear to have made their debut in what were described as "bucket shops."

The bucket shop in 1920s America was made famous by a man named Jesse Livermore. Livermore speculated on stock price movements; he did not own the securities he was betting on, but merely predicted their future prices. At the beginning of his career, he was a stock option bookie, taking the opposite side of anyone who thought a particular stock might increase or decrease in price. If someone came to him speculating the stock of XYZ Company was going to go up, he would take the other side of the trade.

Jesse Livermore's investing philosophy wasn't foolproof, but he's still recognized as one of the greatest traders in history.

Yesterday's bucket shops are equivalent to the more modern illegal shops called boiler rooms. Both have illegal trading activity at their core. The 2000 movie "Boiler Room" depicts stock brokers creating artificial demand for stock in companies with tenuous earnings—if any at all. Eventually, these companies would go under, and the unscrupulous brokers would keep the money used to purchase the shares at artificially high prices. On some occasions, the brokers would make up companies that never existed and pocket the money.

In the beginning, the commodity futures markets and stock options markets were plagued with rampant illegal activities. Today, options are most widely traded on the Chicago Board of Options Exchange (CBOE). Just like the stock markets, options markets activities draw much scrutiny from regulatory agencies such as the SEC, and in some cases, the FBI. Today's commodities market is also highly regulated.

The Commodity Exchange Act prohibits illegal trading of futures contracts and mandates the specific procedures required in the industry through the Commodity Futures Trading Commission. Regulatory agencies are concerned with a variety of issues, many of which stem from the highly computerized nature of today's trading environment. Price fixing and collusion are still issues the agencies try to prohibit in order to create an "even" playing field for all investors.

The Bottom Line

Today's options and futures markets originated centuries ago. This may surprise some investors, who thought stock futures and options were the sole domain of Wall Street power brokers. The Chicago Board Options Exchange (CBOE)—the largest market for stock options—evolved from early market trailblazers like Jesse Livermore.

The first futures markets were created by Japanese samurai who hoped to corner the rice markets, while options can be traced back to the olive trade in ancient Greece. While these instruments originated hundreds of years ago in a world very different from ours, their continued use and popularity are a testament to their ongoing utility.