History Of Chicago Markets

The Chicago exchanges: CBOT and CME

In the United States, the major force catapulting the development and imposition of grading standards was the Chicago Board of Trade, which was established in 1848, and grew to become one of the largest and most successful futures exchanges in the United States and globally. In 1864, the CBOT listed the first ever standardized "exchange traded" forward contracts in the United States, which were called futures contracts. With the ever increasing urbanization of the east coast and growth of train networks, the U.S. demand for commodities blossomed and led to the growth of more intricate trading in forward contracts to sell and buy commodities. The large geographical spread of the U.S. proved to stimulate trading through time and along a sophisticated supply chain with spot and forward markets. Credit risk in these relatively elongated supply chains spanning farms/transit hubs/warehousing/grain merchants had to be properly managed if critical scale was to reached. The CBOT took shape to provide a centralized location, where buyers and sellers can meet to negotiate and formalize forward contracts. The Chicago Board of Trade was not formed with the objective of becoming a futures exchange, rather it initially emerged as a chamber of commerce to support enterprise in Chicago - a logical transit hub for canal/rail given the proximity of the Great Lakes, Prairies and links to industrializing East Coast urban centers.

In 1856, the CBOT designated three quality categories of wheat and provided the criteria for appropriate grading. Warehouse receipts rapidly became aligned to a particular grade without referencing a particular lot. The introduction of the grading system made possible an enhanced fungibility of grains stored in elevators and warehouses. This permitted a delinking of ownership rights from specific lots of the underlying physical commodity. Standardization thereby elevated the acceptability of the receipts. It also furnished the basis on which to construct a liquid market in a manner not unlike Cantillon's description of the operation of Bills of Exchange. These changes pivoted Chicago's grain markets and there scale was set for growth. The Chicago Board of Trade (CBOT), established on April 3, 1848. By the 1980s it was one of the world's most successful futures and options exchanges. July 12, 2007, the CBOT merged with the Chicago Mercantile Exchange (CME) to form CME Group. CBOT and three other exchanges (CME, NYMEX, and COMEX) now operate as designated contract markets (DCM) of the CME Group . In 1919, the Chicago Butter and Egg Board, a spin-off of the CBOT, was reorganized to enable member traders to permit future trading, and its name was changed to Chicago Mercantile Exchange (CME).

The Development of Option trading

MacKenzie and Millo (2003) provide a very readable historical account of the development of option trading from the 1960s to 2003. The Chicago Board Options Exchange CBOE and International Monetary Market IMM emerged from the long established infrastructure of Chicago’s agricultural exchanges. The CBOE was an offshoot of the Chicago Board of Trade (CBOT). The octagonal open-outcry trading pits historically traded futures on grain and other commodities. By the 1960s the trading environment had become difficult for the CBOT and the CME. The heavy hand of government set price floors and contracted to manage periodic surplus and shortage. Prices did not fall or rise precipitously, so much of raison d'etre of futures trading had been eroded. In the late 1960s, the CBOT sought ways to diversify away from agriculture which had been declining inexorably as a proportion of the overall economic activity since the war. Looking for more stable business lines, executives were forced to explore alternatives and expanding the range of futures offerings appeared to offer some respite. The Securities Exchange Commission (SEC) however was adamant that the CBOT should not extend futures trading to stocks. In 1967, the CBOT hired a former presidential aide Henry Hall Wilson, to become its president. Wilson hired Joe Sullivan, a Wall Street Journal political correspondent, as his assistant. To lobby effectively required political insights and that the former aide and correspondent had both in spades. Sullivan got to work quickly and investigated the feasibility of futures on commodities such as fish meal, plywood and scrap steel. Likewise at the CME, Leo Melamed, a trader who had swiftly risen to the executive of the exchange, similarly considered futures on apples. potatoes, shrimp and turkeys. None of these, however, were likely to drum up long term sustainable business activity and something more profound had to be unearthed.

Even as late as the 1960s, the SEC remained deeply skeptical of Futures where no tangible goods were ultimately involved in a physical exchange. The 1929 crash was still vivid enough in the minds of regulators to warrant extreme uneasiness in relaxing control over what should be traded on these exchanges. The Banking crisis and general dysfunction that came in the path of pre-war epoch had shaped the preferences and risk tolerance of bureaucrats who were by and large, starkly conservative in outlook. Fortunately for the CBOT/CME the SEC had political uber masters.

The CBOT had sought to develop a futures contract on a stock market index such as the Dow Jones Industrial Average. That appeared toxic to many regulators and more importantly the Supreme Court ruled against this class of trading in 1905. The logic ran that if a trade could not be settled by physical delivery of a commodity such as grain - it amounted to no more than an illegal wager. With futures snarled up, the CBOT’s Special Committee on Securities began to explore options. At first glance, they appeared to satisfy a number of key criteria: they were legal, there was an underlying asset that could be delivered, and there was some limited trading of warrants in New York. Options however were problematic - particularly to those at the SEC who within their careers had weathered the consequences of 1929 stock market crash. Dealings with the SEC were adversarial in nature and political astuteness would be order of the day. The SEC objected to a futures exchange listing options, leading to the development of a separate exchange, the CBOE.

Life begins at the CBOE

The CBOE, brainchild of Edmund O Connor, was launched on April 26, 1973 in a space that used to be the CBOT’s smoking lounge. The first day’s volume was 911 contracts on 16 stocks. They were all calls as the trading of puts would not be approved for another four years. Interestingly, this coincided with the publication of the Black Scholes model. This had two effects (1) it gave traders an actual way to value options (2) it played a key role in undermining opposition (from regulators) to options. This would open the way for further deregulation

Prior to Black-Scholes Princeton economists; Burton Malkiel and Richard Quandt (1968) pp. 6, 163, 165, and 167 maintained that options’ reputation“as the ‘black sheep’ of the securities field” was inappropriate. Their use was “a very desirable strategy for most investors” and “wholly rational,” although the ad hoc New York options market was “relatively inefficient”. MacKenzie and Millo (2004) pointed out that " Leo Melamed, for example, is in many ways the archetypal American capitalist and close ally of Chicago free-market economist Milton Friedman. (Friedman’s analysis of the benefits of a currency futures exchange, commissioned by Melamed for $5000, was even more central in giving legitimacy than Baumol, Malkiel, and Quandt’s analysis of options.)"

The success of the market relied upon the effective operation of the CBOE’s clearing house and margin accounting. The Chicago Board Options Exchange Clearing Corporation was headed up by Wayne P. Luthringshausen . The latter successfully put into operation pivotal clearing software without which the exchange would have failed. The S.E.C. required one clearing corporation for options for the CBOE. The Chicago Board Options Exchange Clearing Corporation later in 1973 would become the Options Clearing Corporation (OCC) and subsequently became the central clearing house for all options markets in 1975. Today the OCC provides central counterparty (CCP) clearing and settlement services to 16 exchanges. Options, financial and commodity futures, security futures and securities lending transactions can be processed. Like all clearing houses, the OCC acts as guarantor between clearing parties, verifying that the instruments clearing through the OCC are honored in full and contractual obligations are respected. In 2016 the OCC held approximately $100 billion of collateral deposited by clearing members and cleared contract volume totaling 4.17 billion.

While clearing was crucial for the operations of the exchange, growth of the options industrywould have stalled had it not been for the simultaneous development of the Black-Scholes Model, first published in 1973. The Black-Scholes (1973) model will be explored rigorously in the following pages. The Black Scholes model became important in a number of respects. (1) It effectively gave traders a coherent methodology for pricing (2) it seem to settle an intellectual/cultural debate. The risk neutral conditions under which Black Scholes was derived seem to confer legitimacy on what might otherwise have been regarded as pure gambling. Once a trader could show his portfolio was delta neutral he/she could claim their portfolio was legitimately hedged.

According to MacKenzie and Millo (2003) p. 114 "As CBOT officials began to float the idea of options trading with the SEC in the late 1960s, they encountered what they took to be instinctual hostility, based in part upon corporate memory of the role options had played in the malpractices of the 1920s. Sullivan, for example, was told by one leading SEC official that he had “never seen a [market] manipulation” in which options were not involved. When the CBOT invited SEC Chair Manuel Cohen and one of his officials to a meeting with Wilson and Sullivan in the Democratic Club, the official told them that there were “absolutely insurmountable obstacles” to their proposal, and they 'shouldn’t waste another nickel pursuing it.' He even compared options to 'marijuana and thalidomide'".

These arguments fell away once delta hedging and risk neutrality seemed to garner mathematical or axiomatic standing amongst economists and legal scholars.

The relationship between Forwards, Futures and Options

The two basic sorts of options are call options and put options. A call option confers owners with the right to buy the underlying asset at a pre-determined price within a specified period of time. A put option confers the right to sell the asset at a specified price within a particular window of time. The right, as opposed to the obligation, to buy or sell the underlying asset differentiates options from futures or forward contracts. When we trace out the payoffs for options it is observable that options do not have a negative payoff range once we ignore upfront premia typically paid to obtain the option.

Call and Put Payoffs with Premium: no free Lunch

Typically options have value and should not be free. Using the Python code below, we sketch out the effect of premia on the payoff charts for options. The premium is the cost incurred by traders for acquiring the rights conferred by put or call option contracts. The value of an option should not be zero. There should be no free lunch.

The size of an option’s premium is likely influenced by: the price of the underlying market, its level of volatility (or risk) and the option’s time to expiry, cost of carry. In the Python code below we arbitrarily assume the call premium costs 10.45 and the put premium costs 5.57. Later, we develop Black Scholes to price options using a coherent framework.

#https://clinthoward.github.io/portfolio/2017/04/16/BlackScholesGreeks/

import pandas as pd

import matplotlib.pyplot as plt

import numpy as np

plt.style.use('ggplot')

plt.rcParams['xtick.labelsize'] = 20

plt.rcParams['ytick.labelsize'] = 20

plt.rcParams['figure.titlesize'] = 22

plt.rcParams['figure.titleweight'] = 'medium'

plt.rcParams['lines.linewidth'] = 3

def long_call(S, K, Price):

# Long Call Payoff = max(Stock Price - Strike Price, 0)

# If we are long a call, we would only elect to call if the current stock price is greater than

# the strike price on our option

P = list(map(lambda x: max(x - K, 0) - Price, S))

return P

def long_put(S, K, Price):

# Long Put Payoff = max(Strike Price - Stock Price, 0)

# If we are long a call, we would only elect to call if the current stock price is less than

# the strike price on our option

P = list(map(lambda x: max(K - x,0) - Price, S))

return P

def short_call(S, K, Price):

# Payoff a shortcall is just the inverse of the payoff of a long call

P = long_call(S, K, Price)

return [-1.0*p for p in P]

def short_put(S,K, Price):

# Payoff a short put is just the inverse of the payoff of a long put

P = long_put(S,K, Price)

return [-1.0*p for p in P]

def long_fut(S, K, Price):

# Long Futures Payoff = (Stock Price - Delivery Price

P = list(map(lambda x: (x - K) - Price, S))

return P

S = [t/10 for t in range(0,2000)] # Define some series of stock-prices

fig, ax = plt.subplots(nrows=2, ncols=2, sharex=True, sharey=True, figsize = (20,15))

fig.suptitle('Payoff Functions for Long and Short Positions in Puts and Calls', fontsize=23, fontweight='bold')

fig.text(0.5, 0.04, 'Stock/Underlying Price ($)', ha='center', fontsize=14, fontweight='bold')

fig.text(0.08, 0.5, 'Option Payoff ($)', va='center', rotation='vertical', fontsize=14, fontweight='bold')

lc_P = long_call(S,100, 10.45)

plt.subplot(221)

plt.plot(S, lc_P, 'b')

plt.legend([ "Long Call"])

lp_P = long_put(S,100, 5.57)

plt.subplot(222)

plt.plot(S, lp_P, 'r')

plt.legend(["Long Put"])

lf_P = long_fut(S,100, 0)

plt.subplot(223)

plt.plot(S, lf_P, 'b')

plt.legend([ "Long Futures"])

sc_P = short_call(S,100, 10.45)

sp_P = short_put(S,100, 5.57)

plt.subplot(224)

plt.plot(S, sc_P, 'r')

plt.plot(S, sp_P, 'b')

plt.legend(["Short Call", "Short Put"])

plt.show()