MATURING CBOE CONFIDENT AT 20 (original) (raw)

“It is too soon to speak with certainty as to how the birth of the Chicago Board Options Exchange will be treated in the financial history books.”

-Joseph W. Sullivan, president,

Chicago Board Options Exchange,

Aug. 31, 1973.

In a sense, the words written by Joseph W. Sullivan, the first president of the Chicago Board Options Exchange, are as relevant on the market’s 20th anniversary as they were when it was born in a Chicago Board of Trade members’ lounge two decades ago.

As the CBOE honors an important post-adolescent birthday Monday, it is fair to say the behemoth of the nation’s five securities options markets has much to celebrate-surging business returning to its floor; the recent launch of innovative trading products that have caught fire; and an exchange telecommunications network that remains the envy of the world.

Yet the CBOE also has experienced its share of emotional growing pains, most notably the Wall Street market meltdowns of 1987 and 1989. Those traumatic events shook the confidence of outside investors, wiped out the fortunes of some floor traders and brokers, placed a prolonged crimp in CBOE plans for growth and triggered a thorny investor lawsuit CBOE officials settled for $10 million.

On balance, however, the CBOE, conceived by a small group of influential, pioneering individuals from the neighboring Board of Trade-among them Sullivan and Edmund O’Connor-has been looked upon favorably by fortune from its inception.

“Today, our markets are more mature, and the users of our products are far more sophisticated than just several years ago, and we view that as positive,” said William Floersch, CBOE vice chairman, who has bought and sold options on stocks of such blue-chip corporations as McDonald’s and Xerox for 18 years.

“It wasn’t so long ago that our markets were dominated by the proverbial ma and pa investor; but now we see increasing participation from the institutional user,” said Floersch.

The CBOE bears little resemblance to the market that existed on launch day, April 26, 1973, when 200 members-a blend of speculators, hopeless optimists, and dyed in-the-wool entrepreneurialists-crowded into the converted members’ lounge adjacent to the CBOT’s fourth-floor trading arena and began buying and selling call options on 16 equities.

“I recall that day vividly,” said Joseph Marconi, a Michigan Avenue advertising executive who, as the CBOE’s first press-relations officer, was present at the creation.

“There was a great deal of uncertainty when that trading bell rang; many of the Wall Street wire houses (stock brokerages) treated us at arms’ length. They had little faith in this fledgling Midwest exchange and kept asking, `What do a bunch of grain traders in Chicago know about the security business?’ “

By the end of opening day, CBOE floor brokers and traders had bought and sold 911 contracts, a number that exceeded the expectations of many, including James Kipp, a Boston native who purchased a CBOE seat for $25,000 shortly after the exchange opened.

“We thought it would succeed because it was the first time that standardized equity options were offered for trading on an exchange floor and were backed by a clearinghouse,” said Kipp, a former CBOE chairman who, as a designated primary market maker, fuels liquidity in several CBOE options.

But the exchange had a long way to go before it became an officially sanctioned institution because the Securities and Exchange Commission, unsure whether options trading would siphon money from the cash markets in New York by triggering unbridled speculation, initially permitted the CBOE to operate only as a pilot project that it monitored closely.

By 1977, there was little doubt the CBOE would succeed. Seat prices had risen to nearly $100,000; volume trading records were toppling left and right; the number of listed options on equities had climbed to 120; and the exchange had moved to a new, expanded, 20,000-square-foot trading floor in the Board of Trade Building. Moreover, market leaders now listed puts, which give investors the right to sell a stock at a certain price and time, along with calls, which allow them to buy.

In addition, the American Stock Exchange, the New York Stock Exchange, the Philadelphia Stock Exchange and several other cash markets, smarting under Chicago’s success and their lack of foresight, had established options-trading arenas. None has made significant inroads on CBOE’s dominant market share.

On March 11, 1983, the CBOE launched options on two stock indexes, trading vehicles that led to a virtual revolution in securities trading and helped push trading volume from 82.4 million that year to more than 123 million 12 months later. The two indexes-the Standard & Poor’s 100 and the S&P 500-now represent 92 percent of the U.S. index options market.

The CBOE, all agree, was the brainchild of O’Connor, at the time the Board of Trade’s vice chairman, and Sullivan, a former Wall Street Journal reporter in Washington who had come to the Board of Trade in 1967 at the request of the late Henry Hall Wilson, who was exchange president. Sullivan, a Knoxville native who studied liberal arts at Princeton and journalism at Columbia, had caught the eye of Wilson while Wilson was President Lyndon Johnson’s liaison to Capitol Hill.

(Sullivan declined to be interviewed for this article.)

Board of Trade grain markets, cyclical by nature, had hit the doldrums in the late ’60s, member profits were in the tank and traders and brokers were leaving the exchange in droves. To try to reverse the disturbing trends, O’Connor began casting about for new products to trade and placed Sullivan at the head of a research-and-development team. Four years later, that team produced a unique proposal-trading standardized stock options with fixed strike prices and durations on an organized exchange.

“Both the Board of Trade and the Chicago Mercantile Exchange saw the need to diversify their product lines,” recalled O’Connor, who with his brother, William “Billy” O’Connor, went on to make millions with their company, First Options, at one time the CBOE’s largest clearing member firm.

“At the time, stock options were being traded over-the-counter by a small group of New York firms. . . . We thought we could carve out that business for ourselves, and we were successful; those firms no longer exist,” Edmund O’Connor said.

O’Connor noted that there was no Commodity Futures Trading Commission in the early ’70s. So to get the green light to proceed with their proposal, he and Sullivan had nowhere to go but the SEC-the securities industry regulator, whose antipathy and mistrust of futures trading was well known. Because Board of Trade members were disinclined to open their market to SEC review, it was decided to incorporate the CBOE as an independent body in February 1972, with its own bylaws and governing board.

In recognition of the key role the Board of Trade played in the CBOE’s creation, the Board of Trade’s approximately 1,200 full members, known as yellow badges, were given the right-in perpetuity-to trade CBOE products.

To accommodate surging growth in business, the CBOE’s 931 regular members moved to their present home in 1984, a 45,000-square-foot trading arena that is the largest and most technologically advanced in the world, according to CBOE President Chuck Henry. Technology enhancements include RAES, an electronic system that fills small customer orders automatically at the prevailing bid and offer; auto quote, which updates market quotes in less active option series; and the electronic book, which increases the speed of order execution, Henry noted.

Since Oct. 19, 1987, when the Dow Jones industrial average dropped more than 500 points, and again in October 1989, when Wall Street was hit with a mini-crash, the CBOE has not been the same market, observers note.

Trading volume remains well below the record 182 million puts and calls traded in 1987, the CBOE’s budget has shrunk to 65millionfromcloseto65 million from close to 65millionfromcloseto100 million in the late ’80s and there have been several rounds of layoffs.

Yet a silver lining of sorts has emerged from the market turmoil of the late ’80s, said CBOE Chairman Alger “Duke” Chapman. Before the 1987 crash, the small retail investor accounted for about 90 percent of the business coming to the exchange, with 10 percent coming from institutional traders; now, institutional participation is about 40 percent.

The retail customer, who still accounts for more than half of CBOE business, also has changed, noted Chapman. No longer the proverbial dentist from Iowa, the retail customer typically is older than 45, has an annual income exceeding $100,000 and is versed in CBOE trading products and investment strategies.

In the last four years, the CBOE has launched a number of seemingly arcane investment vehicles that are helping to inch business back up near 1987 levels, bolstering membership seat prices. A product known as LEAPS, allowing investors to buy options of long duration, has reached open interest of 750,000 contracts, for example.

The exchange also has sought SEC permission to list a number of new contracts that are tailored to the needs of CBOE market users and designed to capture some of the business going into over-the-counter markets. The exchange is seeking permission to trade options on a volatility index; a family of eight sector indexes, including health, banking and insurance; and customized interest-rate contracts.

This summer, CBOE faces a major hurdle when, as mandated by the SEC, the nation’s four other options markets will be able to list any or all of the Chicago market’s most actively traded options. CBOE leaders say they are confident, however, the mandate will not dent their dominant market share.

“Our challenge and our focus is to educate a new generation of investors and brokers about options and to continue to be the innovative exchange that transformed the concept of a listed options market into the world’s premier option marketplace and the second-largest securities market in the U.S.,” said Chapman.

Originally Published: April 26, 1993 at 1:00 AM CST