BEFORE BLACK SCHOLES- HOW OPTIONS WERE TRADED BEFORE THE QUANTS ARRIVED

Before the advent of the ground-breaking Black-Scholes model, the world of options trading operated in a vastly different manner. This article delves into the fascinating history of options trading, exploring the methods and practices that were employed before the arrival of the quants.

Options, which are financial derivatives granting the holder the right but not the obligation to buy or sell an underlying asset at a predetermined price within a specific timeframe, have a long and storied past. Dating back to ancient times, options were utilized in various forms across different cultures.

One of the earliest instances of options trading can be traced to ancient Greece, where Thales of Miletus, a renowned philosopher and mathematician, reportedly used options contracts to predict a bountiful olive harvest. By purchasing the exclusive rights to use olive presses in advance, Thales gained significant leverage over the market and was able to command high prices when the harvest was indeed plentiful.

Moving forward in time, the evolution of options trading continued. In the 17th century, the Amsterdam Stock Exchange emerged as a hotbed of financial innovation. Traders began to engage in what is now known as "put" options, allowing them to sell specific quantities of stock at predetermined prices. These early options contracts were often informally traded among merchants, and their terms were subject to negotiation and agreement.

The 19th century witnessed the birth of organized options exchanges, providing a more structured framework for trading. One notable example was the Chicago Board Options Exchange (CBOE), which was founded in 1973. Prior to the arrival of the quants and complex mathematical models, options trading on the CBOE largely revolved around a method called the "open outcry" system.

In the open outcry system, traders would gather on the trading floor, using hand signals and vocalized bids and offers to communicate their intentions. This lively and chaotic environment was a far cry from the sophisticated algorithmic trading prevalent in today's markets. The open outcry system relied heavily on human judgment, intuition, and interpersonal skills.

The lack of complex mathematical models meant that options pricing was more art than science. Traders would estimate the value of options based on a range of factors, including the underlying asset's price, time remaining until expiration, market volatility, and the trader's own instincts. While some traders developed successful heuristics and rules of thumb, there was no systematic approach to valuing options.

Risk management was another crucial aspect of options trading before the quants. Without the benefit of sophisticated risk models, traders relied on basic principles to manage their exposure. Techniques like diversification, position sizing, and stop-loss orders were used to mitigate risk, but these methods were more rudimentary compared to the complex risk models developed by quantitative analysts later on.

The equilibrium-based Capital Asset Pricing Model (CAPM) was widely used before Black-Scholes. Depending on the investor's preferences, the risks and rewards were balanced, so a high-risk investor may expect to be paid with (the possibility for) larger returns in a similar ratio.
In a paradigm shift from risk-based models (such the CAPM), Black-Scholes is still the first arbitrage-based model. The CAPM stock return notion was superseded by the new BS model's awareness that a perfectly hedged position will yield a risk-free rate.

As a result, risk and return fluctuations were eliminated, and the idea of arbitrage was founded. In this concept, valuations are carried out under the premise that a position is hedged (risk-free), which should result in a risk-free rate of return.

The arrival of the quants and the Black-Scholes model in the 1970s revolutionized the options trading landscape. The Black-Scholes model, developed by economists Fisher Black and Myron Scholes, introduced a ground-breaking formula for valuing options. This formula, built upon concepts from stochastic calculus, enabled traders to quantify and price options with a level of precision that was previously unimaginable.

The Black-Scholes model took into account variables such as the underlying asset's price, time to expiration, strike price, risk-free interest rate, and volatility. By plugging these inputs into the formula, traders could calculate the theoretical value of an option. This allowed for more informed decision-making, improved risk management, and the development of sophisticated trading strategies.

The Black-Scholes call option formula is calculated by multiplying the stock price by the cumulative standard normal probability distribution function. Thereafter, the net present value (NPV) of the strike price multiplied by the cumulative standard normal distribution is subtracted from the resulting value of the previous calculation.

With the rise of computing power, options trading became increasingly reliant on mathematical models. Quants, armed with advanced mathematical and statistical techniques, began developing complex models to identify trading opportunities and manage risk. These models utilized historical data, volatility measures, and advanced mathematical algorithms to generate trading signals and optimize portfolios.

Today, options trading is a highly sophisticated and automated industry. Quantitative analysts and algorithmic trading systems dominate the landscape, employing intricate models and advanced trading strategies. However, it's important to recognize the rich history and evolution of options trading that laid the foundation for the innovations that followed.

In conclusion, options trading before the advent of the quants and the Black-Scholes model relied on human judgment, negotiation, and basic risk management techniques. Traders estimated the value of options based on intuition and experience, without the aid of complex mathematical models. The arrival of the quants and the Black-Scholes model revolutionized options trading, introducing sophisticated pricing models and paving the way for the development of quantitative trading strategies. While the industry has come a long way, it is essential to acknowledge the historical roots and appreciate the ingenuity of those who traded options before the quants arrived.

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