The CBOE and Black-Scholes: Options Become a Listed Market, 1973

On 26 April 1973 a room in the Chicago Board of Trade building that had lately served as a smokers' lounge opened for business as a securities exchange. The fittings were improvised, the staff numbered a few dozen, and the traders standing on the floor dealt in an instrument that senior officials at the Securities and Exchange Commission had spent four years explaining could not be listed. By the close they had traded 911 contracts on sixteen underlying stocks.

Someone had chosen the date for sentiment. It was the 125th anniversary of the Chicago Board of Trade, the grain exchange that had paid for the venture and lent it the room. Nothing else about the day announced itself. Two months later a paper appeared in the Journal of Political Economy that gave the new market a price, and within a decade the combination had changed what a financial institution could own, hedge and sell.

Twenty Firms in New York

Options on shares were centuries old and, in 1973, barely a market. Business ran through the Put and Call Brokers and Dealers Association, roughly twenty firms in New York that matched a buyer who wanted a call with a seller willing to write one. Every contract was negotiated: strike price, expiry date and size were whatever the two parties agreed, and the contract was endorsed by a member firm that guaranteed performance.

That design had one consequence that mattered more than all its others. A negotiated contract is not interchangeable with any other contract, so there was no secondary market. A buyer who changed his mind before expiry could not sell his option to a third party; he could only go back to the dealer who had written it and ask for a price, or exercise, or let it lapse. Volume was correspondingly small, spreads were wide, and the whole business had a reputation — earned in the 1920s and never shaken off — as a bucket-shop trade for people who could not afford the stock.

Academic finance had not solved it either. Louis Bachelier's Théorie de la spéculation of 1900 had modelled option values using a random walk, and the problem had attracted intermittent attention since, but nobody had produced a formula that gave a single defensible number. Edward Thorp and Sheen Kassouf published Beat the Market in 1967 with a practical valuation method for warrants, and Thorp traded on it profitably, which is a different achievement from persuading a regulator.

Seven Years of No

Edmund O'Connor, a Chicago Board of Trade vice chairman who had made money trading grain, put the idea forward in the spring of 1969. The exchange's problem was straightforward: grain volumes were flat, the membership had capital and floor skills, and there was no obvious new agricultural product to list. Options on shares were a business that used the same machinery and served a different customer.

Jurisdiction was the obstacle. Futures on farm products fell under the Department of Agriculture; options on equities were securities, which put them under the SEC, an agency with no history of approving anything of the kind and considerable institutional memory about why. The Board of Trade hired Joseph Sullivan, a Wall Street Journal reporter, to manage the regulatory approach and to sell the concept in New York.

Sullivan's account of the first meeting has not softened with retelling. At the SEC around the beginning of 1969, he recalled, the senior staff member told the Chicago delegation that there were "absolutely insurmountable obstacles" and that they "shouldn't waste a nickel on it."

What eventually moved the Commission was standardisation. Chicago proposed to fix the terms the put-and-call dealers had negotiated: contracts of 100 shares, strike prices set at intervals, expiry restricted to four months a year on a fixed cycle. Every contract on a given stock, strike and month would then be identical to every other, which made it fungible and gave it a secondary market. A clearing corporation would stand between buyer and seller, so no holder needed to know or trust the writer, and positions could be closed by an offsetting trade with anyone on the floor.

In February 1972 the Chicago Board Options Exchange was incorporated as a separate body with its own bylaws and governing board, and Sullivan became its president. The clearing entity opened alongside it under Wayne Luthringshausen and, as other exchanges joined, became the Options Clearing Corporation — a single guarantor for the whole listed options industry, which is what it remains.

Two Papers, One Year

Fischer Black and Myron Scholes had been working on option valuation since the late 1960s, Black as a consultant with a doctorate in applied mathematics and Scholes as a young finance professor. Their insight was that an option's value does not depend on anyone's forecast of the stock. A position in the option can be offset continuously by a position in the underlying shares, and a portfolio hedged that way earns the riskless rate, which pins the option's price to five observable quantities: the share price, the strike, the time remaining, the interest rate and the volatility of the stock.

The paper was turned down before it was published. The Journal of Political Economy rejected it, as did the Review of Economics and Statistics, and it appeared in the Journal of Political Economy only after Chicago faculty pressed the case — in the issue dated May–June 1973, four to six weeks after the CBOE had opened its doors (Black and Scholes, 1973).

Robert Merton, working at MIT and in correspondence with both men, published "Theory of Rational Option Pricing" in the Bell Journal of Economics and Management Science the same year. His derivation was more general, it extended the result to dividends and to other contingent claims, and it was Merton who gave the thing the name that stuck (Merton, 1973).

The timing was luck rather than coordination. Chicago had spent four years arguing a regulatory case and had not been waiting on a theory; Black and Scholes had been trying to publish for three years and were not writing for an exchange. They arrived within weeks of each other, and each made the other useful.

The Market That Nearly Died First

Volume in the first weeks was thin: 34,599 contracts in the first full month. By June 1974 average daily volume had passed 20,000 contracts, which the exchange counted as survival.

It had reason to. The CBOE opened four months after the top of the worst equity bear market since the 1930s. The Dow Jones Industrial Average had peaked at 1051.70 on 11 January 1973 and fell to 577.60 in December 1974, a decline of more than 45 per cent, driven by the collapse of the Nifty Fifty one-decision stocks, the oil embargo and the unwinding of the dollar system.

A new exchange listing only call options, in a market where every call expired worthless for eighteen months, had every reason to fail. It grew instead. Falling prices gave institutions a reason to want the thing the CBOE sold, and writing calls against stock they already held was one of the few ways to earn income from a portfolio that was losing value. Demand for hedging does not require optimism.

Competition confirmed the product before the profits did. The American Stock Exchange and the Philadelphia Stock Exchange opened their own options floors in 1975, two years after Chicago had been told the business was impossible.

The Formula Reaches the Floor

What happened next is the part economists find interesting. A pricing model published in an academic journal became, within about five years, the working vocabulary of a trading floor whose members had mostly not read it.

Black supplied the bridge himself. From the mid-1970s he produced and sold computer-generated sheets of theoretical option values, priced off his own formula, to traders who wanted a number to trade against without doing the arithmetic. Donald MacKenzie and Yuval Millo's study of the period traces how those sheets, and the calculators that followed, turned the model from a description of prices into an instrument that set them: quotes converged on model values because participants used the model to make them (MacKenzie and Millo, 2003). Texas Instruments was selling a calculator with the formula programmed in by 1977, and Black — who had asked for a royalty and been refused — found his name in the advertising.

Black's own 1975 survey in the Financial Analysts Journal is the more revealing document, because it is a practitioner's paper rather than a theorist's. He set out how the formula behaved when its assumptions failed, warned that its volatility input was an estimate and not an observable, and noted which of the strategies then being marketed to investors did not do what their sellers claimed (Black, 1975).

Firms built on the arithmetic soon dominated the floor. O'Connor & Associates, founded in 1977 by the mathematician Michael Greenbaum with capital from Edmund and William O'Connor, made markets off modified versions of the model and by 1988 was the largest options market maker in the United States; Swiss Bank Corporation bought it in 1992. The pattern of quantitative market-making firms growing out of the Chicago options pits and then being absorbed by banks repeated often enough to become the standard route by which derivatives expertise reached global institutions.

Washington Pulls the Handbrake

Growth brought scrutiny. Put options were listed in 1977 — the exchange had opened with calls only, since the SEC regarded a listed put as a short position available to the retail public — and annual options volume reached 25 million contracts that year. Sales practice complaints followed, and in 1977 the Commission imposed a moratorium on any further expansion of the options markets while it reviewed the industry's regulatory structure.

That freeze held for nearly three years. It ended on 26 March 1980, and the CBOE promptly raised the number of stocks on which it listed options from 59 to 120.

Settling in Cash

The 1983 listing was the structural leap. An option on an index cannot be delivered, because there is no certificate to hand over, so the contract settles in money against the index level. Approving it meant deciding that a contract with no possible physical delivery was not a wager, which is precisely what nineteenth-century anti-bucket-shop law had been written to prohibit — the same question Chicago's futures side had put to its own regulator when it listed currency futures on the International Monetary Market in 1972.

Options on the CBOE 100, later the S&P 100 and known by its ticker OEX, began trading on 11 March 1983 as the first cash-settled securities product. Options on the S&P 500 followed four months later. An institution could now buy insurance on a whole equity portfolio in one trade, which is what had previously required either selling the portfolio or writing calls on every name in it. Annual volume on the exchange passed 100 million contracts in 1984.

Ten years on, the exchange commissioned Robert Whaley to build an index from the implied volatilities of at-the-money OEX options, and the VIX began publication in 1993. Its input is the volatility term in the Black-Scholes formula, read backwards out of market prices — the one quantity in the model that cannot be observed, turned into a quoted benchmark and eventually into futures and options of its own.

What the Model Could Not Do

The assumptions carried risks that the arithmetic concealed. Black-Scholes treats returns as lognormally distributed with constant volatility, which understates the probability of large moves, and it assumes a hedge can be adjusted continuously in a market that always has a bid. Both assumptions failed on 19 October 1987, when portfolio insurance programmes derived from the same option-replication logic sold into a market with no buyers and the Dow fell 22.6 per cent in a session (see Black Monday and the machines that broke the market). The persistent volatility skew in index options dates from that week: traders have priced crash risk above what the lognormal model implies ever since, and have not stopped using the model to quote it.

Scholes and Merton shared the Nobel memorial prize in economic sciences in 1997. Black had died in 1995 and the prize is not awarded posthumously. Within a year both laureates were principals at Long-Term Capital Management when it lost most of its capital and required a creditor-organised rescue, a sequence examined in the collapse of Long-Term Capital Management. Merton Miller's verdict on that episode was that the firm's failure had come from leverage and liquidity rather than from any defect in the pricing of options, which is correct and was not much consolation.

The room in the Board of Trade building held 911 contracts on its first afternoon. What the sixteen listings of 26 April 1973 established was not a price for options — Black and Scholes were still in review that week — but the far duller precondition for one: that a promise about a share could be made identical to every other promise of the same shape, guaranteed by a clearing house instead of a counterparty, and sold to a stranger who would never learn who wrote it.