I Caught the Trading Bug -1
Adventures in options land
The trading bug bit me!
It was 1990, I’d been working on the Chicago Mercantile Exchange trading floor for more than a year and had a strong hunch about the direction of the stock market. My conviction was so strong that it was time to put some money on the line.
In my own way, I was following the trading adage: “When you have a hunch, trade a bunch.” I didn’t have a bunch, but I was going to trade my hunch.
I have owned a few stocks since graduating from high school. Grandma gave me two shares of AT&T as a graduation present, in 1980. I started buying shares of IBM when I worked there as a summer hire (summers of 1982, 1983 and 1984). Those were buy-and-hold investments.
Now, I was into purely short-term market speculation. The Dow Jones Industrial Average (DJIA) had just failed to break through the 3,000 level. This seemed to be a major technical sign that the market was headed lower. I wanted to short (sell) the market. That’s not easy to do on an outright basis. To do that would involve opening a margin account and putting up a lot of cash that I didn’t have. There was another possibility, within financial reach. I could achieve a similar goal by trading equity options.
Ethically, and as a condition of my employment at Futures World News, I could not trade in the markets or even exchanges that I covered. So, no trading futures or options on futures. I thought it might be sketchy to trade any stock index products as well. I was not precluded from trading options on individual equities. My idea was to purchase out-of-the-money put options on an equity that would be a good proxy for the Dow Jones Industrial Average. My choice was Motorola.
I’ve been interested in options since the late 1980s. I was covering the wholesale petroleum markets for U.S. Oil Week and the New York Mercantile Exchange (now a part of the CME Group) was launching heating oil options. I learned about puts and calls, straddles and strangles. It was a mish mash of terms and concepts. I struggled to explain the concept to the newsletter’s wholesaler readers.
Comparably, petroleum futures were more tangible and comprehensible. Though the idea of shorting or selling the market was still a tough idea to wrap my brain around.
An option is comparable to a term-insurance policy. It has time to expiration. The cost is called a premium. Both can be used as hedges against catastrophe. I was not doing that.
There are two types of options: calls and puts.
A call is the right, but not the obligation to buy a specific stock, at a specific time, at a specific price. Buying a call is a bullish move. It profits as the price of the underlying stock rises.
The call’s counterpart is the put. A put is the right but not the obligation to sell a specific stock, at a specific time, at a specific price. Buying a put is a bearish move. It profits as prices drop.
Note the use of the phrase “right, but not the obligation”. An option buyer does not have to exercise (the option equivalent of filing a claim on an insurance policy) the option. They could let it expire. The seller, however, does not have similar generous terms. They must be prepared for the possibility that the buyer wants to exercise the option. The seller’s upside is that if the option expires unexercised, they get to keep all the premium. (Are you still with me? Questions?)
It's possible to buy options. It’s possible to sell options (a process known as writing the option). Selling a call is a bearish move. Selling a put is a bullish move. You can buy a call and a put at the same strike price, which negates market directional bias and is a speculation on the market volatility. Buying a straddle is a bet that market volatility will rise. Then there’s the strangle. That’s when you buy an out-of-the-money call and an out-of-the-money put (with different strike prices) and . . .
Grasping the abstract concepts of algebra were one of the windmills I tilted against in junior high school. Options were a bigger windmill.
A Google search revealed an interesting history about options. The first recorded option was traded in 332 BC in Greece by the philosopher Thales of Miletus. Aristotle recounted the details of the deal in his book “Politics”, according to optionstrading.org. Much of the rest of this brief history comes from that website.
Thales had an interest in math and astronomy. His studies led him to conclude that his region was expected to see a bountiful olive harvest. Accordingly, the demand for olive presses should soar, he surmised. A profit opportunity was developing. The question was how to realize it. Thales did not have enough money to buy the presses outright. Instead, he contacted the press owners to buy the right to use the presses. He paid a fee smaller than the cost of the press, but locked up the right to use the presses. (Basically he bought the right to be first in line.)
His money was well-spent. The harvest was huge and the demand for presses strong. Thales sold his rights (options as we call them today) to the olive oil producers and raked in the cash.
The saga of options continued to have its ups and downs until the late 19th Century, when an options trading ban in the U.K. was finally lifted. Meanwhile, over-the-counter options markets were developing both in the U.S. and in the U.K. There was interest in trading options, but the market was lacking something . . .
In the late 1960s, traders at the Chicago Board of Trade (CBOT) were concerned about falling futures trading volume. They saw an opportunity to open a new exchange to trade equity options. On April 26, 1973, the new Chicago Board Options Exchange (CBOE) opened, listing options on eight stocks. A key marketing point was that the options were “standardized” and trading was backed by a clearing house. The missing piece had been found.
At first, the CBOE only offered trading in call options. Put options were not allowed. Shorting the stock market has long been a taboo subject.
The Securities and Exchange Commission, the CBOE’s regulator, eventually figured out that traders had found a way to circumvent the rules and create synthetic put positions using the underlying stocks and calls. They approved exchange-based put trading on June 3, 1977, according to a history of the CBOE by Joe Sullivan, the first president of the CBOE.
Two other developments accelerated the growth of options trading. The first was the development of the hand-held electronic calculator. This device allowed traders to calculate options prices using a newly published pricing model. The model was developed by two MIT business school professors: Fischer Black and Myron Scholes. The model could be used to price options. They published their formula in 1973. They, along with Robert C. Merton, another MIT professor who published on the topic, won the Nobel Memorial Prize in Economic Sciences in 1997.
Wikipedia explains how the model works: “The main principle behind the model is to hedge the option by buying and selling the underlying asset in a specific way to eliminate risk. This type of hedging is called "continuously revised delta hedging" and is the basis of more complicated hedging strategies such as those used by investment banks and hedge funds.”
Perhaps it's becoming clearer why a non-math major felt overwhelmed trying to understand this market.
Coming up — adventures and lessons trading these things.
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This blog is about more than my experiences. It is intended to be a collective experience of working on the commodity markets physical trading floor. If you or someone you know has a story please let me know I’d like to include it in this ongoing chronicle. I can be reached at linton122@gmail.com
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