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Talking Indexes
Options Before Quants
Looking at a ‘new’ idea that’s
been around a long, long time
By David Blitzer
Today options and investing with options means
quant models, debates over how to measure implied
volatility, or strategies to trade futures on the VIX.
This modern era in options began in 1973 with the publication
of Black-Scholes, 1 the first practical theory about
options prices. But of course, options didn’t begin with
Black-Scholes; some argue that both Greek mythology and
the Bible include discussions or at least allusions to options
trades. Sticking to written historical records and options
similar to current ones, options history can easily reach
back to the early 1600s in Amsterdam.
At that time, Amsterdam was the leading European
financial center, and the center of innovation. In 1602,
the Dutch East India Company was the first stockholderowned
corporation listed with shares that could be traded
and held by people not otherwise linked to the company.
While trading was active, settlement procedures were
monthly, and recording ownership on the company’s
books was more complex than today.
Though electronic trading was four centuries in the
future, the market was sophisticated and experienced in
trading equities, commodities and fixed-income instruments.
Options—both puts and calls—on Dutch East
India Company stock were actively traded as well. 2,3 If the
Amsterdam market in this historical context rings a bell for
readers, remember that it is the same market that would
experience a bubble in tulip bulbs in 1634-37—a bubble
built on options and futures, not the cash market.
Options trading without quantitative pricing models
thrived. Research depended on a combination of technical
and fundamental analysis. The latter included information
regarding the local economy where the Dutch
East India Company’s ships would be delivering their
cargos; reports of economic conditions in India and
South Asia where the ships bought and loaded cargos;
and rumors of sailing and weather conditions, shipwrecks
and other hazards. Options trading was supported by two
factors: 1) with limited information, many investors preferred
options to stocks because the downside risks could
be limited; and 2) the share price for the Dutch East India
Company was high, and options were a way to invest
without risking too large a proportion of one’s wealth.
As the old Dutch traders knew, options are analytically—and
historically—similar to insurance. A put on a
stock is one way to purchase insurance to limit downside
risk. Writing a call can be thought of as insurance to the
buyer of a call as well—insuring against the regret suffered
if one doesn’t buy a stock and misses a big move. In
either case, the writer is offering insurance and is paid a
premium for accepting the risks while having no control
of whether the option is exercised.
Options have changed and expanded since the 1600s.
With the support of various quantitative models and
theories, we now think we understand them better. Their
coverage can also be broader today than a single stock or
a single risk. Through options on indexes, one can insure,
or accept risk on, a portfolio of stocks. Further, to the
extent that a particular portfolio is similar to a widely recognized
index, one can insure, or add risk to, one’s own
personal portfolio through the use of options.
Many investors looking back at the last few years of
financial turmoil would like to insure their entire portfolio,
maybe their total net worth, against all risks. Until the S&P
500 lost 50 percent twice in the last decade, we all thought
that was a once-in-a-lifetime event. Until the financial crisis
began in 2007, we were completely convinced the Great
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November / December 2012