From Paper to Python: A History of Options Trading Processes

In today’s information-rich, fintech-forward, low-commission trading environment, retail investors can access the options market more easily than ever before. The tools to analyze, implement and execute automated options trading strategies at levels of sophistication previously reserved for institutional-type market participants are now easily accessible for retail investors. The cherry on top? These tools are frequently available at a low cost. We discussed these ideas with Kirk Du Plessis of OptionAlpha on a recent episode of Cboe’s Tales of the Tape podcast. Access the show on the below platforms (or watch it at the end of the article).

Spotify | Apple | YouTube

Early Days of OTC Options

Today’s simplified experience is quite the departure from the history of options trading, which has been typified by heavily manual processes. It was only 52 years ago that Cboe ushered in the era of standardized, listed options trading and helped propel the electronification and automation of the industry. The history of options as an unlisted, bilaterally negotiated product extends centuries prior. In the United States, over-the-counter options were traded as far back as the 1790s – it only took a few years after the Buttonwood Agreement for Wall Street to realize the benefits of options!

In 1875, a handbook for investors from the brokerage firm Tumbridge & Company called Secret of Success in Wall Street highlighted the benefits of securing “privileges” – which would come to be called “options” later in history.

Credit: “Secret of Success in Wall Street” from Tumbridge & Co. (1875)

Options were not spared from the devastation of the Great Depression. The product was maligned during the Congressional hearings of the early 1930s that ultimately brought about the formation of the Securities and Exchange Commission. The Investment Act of 1934 allowed for the existence of options and gave the SEC power to regulate their trading. But for nearly four more decades, the options market remained small, and there was no publicly listed options market. Options could only be traded over the counter (OTC), and they were not widely used. For example, annual volume for OTC options trading reached 300,000 contracts in 1968 – today, more than 500,000 SPX options contracts trade per hour.

In those pre-Cboe days, stock options markets were controlled by put-call dealers who would advertise ‘specials’ (secondary options offerings) in newspapers.

Source: Herbert Filer, Understanding Put and Call Options (1959)

If an individual wanted to trade an option (or simply get a quote for an option), they had to call the dealer and negotiate terms. With a trade consummated, a physical contract was prepared with all the terms: date of the contract, underlying security, days to expiration, strike price, and an endorsement by a NYSE member firm guaranteeing the terms of the contract.

If that doesn’t sound antiquated enough, exercising the option required actual physical exercise. A contract owner wishing to exercise their option had to find the cashier of the stock exchange member firm that endorsed the contract and present it to them prior to the expiration (3:15pm EST). Thus, dealers recommended keeping the physical contracts in New York City to help avoid the prospect of “late presentation.”

If an option holder wished to liquidate the contract prior to expiration, they had to turn to the put-call dealer’s network to find a buyer. Since the dealers were not market makers, they had to find a natural counterparty who wanted to purchase the option. It was not uncommon for a dealer to place 50 calls before finding the other side of this trade, which could take a whole day.

If a buyer could not be found, the dealer would exercise the option, buy/sell the corresponding stock with the contract holder receiving the proceeds, minus the stock trade commissions and taxes. In other words, options trading was a manual, friction-laden process.

And since the OTC options markets were extremely opaque and the Black-Scholes pricing formula hadn’t even been invented yet(!), the end investor had little clarity about whether they were receiving a good price for their option.

A New Era for Listed Options

The founders of Cboe saw an opportunity to improve this process, and bring options trading to more people. Cboe introduced the first U.S. listed options market in 1973 with standardized terms, centralized liquidity, a dedicated clearing entity, and some green shoots of electronification (in the form of CRT monitors).

But for many decades, access to options markets remained a manual, phone-driven game for retail traders. Brokers, market makers and institutions with a presence on the trading floor began to reap the digital benefits sooner with the introduction of tools like handheld computers for pricing and electronic systems for order submissions.

Here’s what the actual execution of a retail order looked like on Cboe’s trading floor in the early days:

Credit: Cboe

Even if the processes described above had been electronified and automation was accessible to retail traders, say, 20 years ago, transaction costs (including the spread and commissions) would have remained a significant hurdle. A viable strategy today might not have been practical when standard stock trading commission rates were $10 or more. It took the “Great Brokerage-fee Wars” of 2017-2019 for those rates to descend to near $0.

Even once the online brokerages were well-established and the trend toward electronification was clear, retail options traders had to be tethered to their screens, manually monitoring positions and reacting to market fluctuations. That is no longer the case with the plethora of trading tools available.

Unleashing Automation

Now, automation offerings allow traders to translate their carefully considered strategies into code. As Option Alpha’s Kirk DuPlessis discusses on the Tales of the Tape podcast, this may help ensure consistent execution and trade management, removing emotional biases and the potential for human error in fast-moving markets. Imagine setting specific entry and exit criteria based on back-tested analysis and having those trades executed precisely as planned.

The ability to automate can allow traders to scale their strategies efficiently, manage a larger number of trades based on predefined rules and, with real-time data, also allows for the continuous monitoring and optimization of strategies. This extends to even multi-legged, more complex strategies like condors, ratios and calendar spreads.

With ease and precision comes great responsibility and new implications for trading psychology. Automated tools present exciting opportunities, but it's crucial for retail traders to approach this with a commitment to education and some caution as they learn the ropes. Understanding the intricacies of options trading – whether using an automated strategy or not – remains paramount.

Watch the latest episode of "Tales of the Tape" to learn more about expanding access to sophisticated options trading.

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