Celebrating 50 Years of Listed Option Trading at the CBOE

Joe
Sullivan

Founding President, Chicago Board Options Exchange

 

Forward by Lawrence G. McMillan

The CBOE’s first President, Joe Sullivan, was “everything” to the creation of the CBOE. In this article, written by Joe himself, the inner workings of politics – both in Washington and in Chicago – exchanges, and traders, all combined to make for a very interesting four years of legwork needed to start the CBOE. Joe did a tremendous amount of soothing, cajoling, and arm-twisting (I’m sure) to get the CBOE off the ground. He served as the inaugural president of the CBOE from its founding in 1973 until 1979.

Unfortunately, Joe passed away on Oct. 2, 2020 at the age of 82. But his work lives on.

This article not only takes you through the initial startup nightmares in dealing with the SEC and various politicians, but later describes how the other exchanges came to be (along with dual listings), how the Options Clearing Corporation (OCC) was created, and eventually how the industry managed to survive a virtual shut-down by the SEC.

This following article was posted to the SEC Historical website in 2019.
 

The Advent of The Chicago Board Options Exchange: A Golden Anniversary Memoir By Its Founding President

By Joe Sullivan

April 26, 1973, was a momentous day in the history of the world’s financial markets. It marked the opening day of trading on the Chicago Board Options Exchange and with it the advent of what was probably the most important stock market innovation of the 20th Century.

For those of us who had assembled for the opening ceremony, it was anything but clear what the CBOE’s destiny would be. The ceremony took place in what until a few months prior had been a musty smoking room adjoining the Chicago Board of Trade’s huge commodity futures trading floor. But now the room was rimmed by eight boothlike trading posts topped by big CRT screens that would display the prices of financial instruments the likes of which the world had never seen before...

Continue reading the full article on the SEC Historical Website »

Bill
Brodsky

Former CEO and Chairman, Chicago Board Options Exchange

 

Interview by Lawrence G. McMillan, 4/27/2023

Bill Brodsky was the CEO and Chairman of the CBOE from 1997 to 2013 and continued on as Chairman until 2017. Bill was involved in the listed option markets from the beginning and was instrumental in bringing the CBOE through many of its most important advances, including electronic trading and overseeing the company go public.
 

Q: Bill, how did you get involved with options in the first place?

After getting my law degree in 1968, I joined the Wall Street brokerage firm of Model Roland & Company in 1968, in the compliance department. Later (in 1974) Model Roland merged with Shields & Co., to become Shields Model Roland, which eventually merged with Bache (in 1977). Model Roland was an institutional firm. At one time, there had been an option department, dealing in the older style over-the-counter options. Ironically, that department was headed by Leon Pomerance, who later became the first Chairman of the CBOE (although Leon worked for DLJ – Donaldson, Lufkin, Jenrette by then). But when two fellows: Joe Sullivan and Gary Knight came to visit Model Roland prior to the founding of the CBOE, the option department at Model Roland no longer existed (and Leon Pomerance had moved on to another firm). The firm had felt there was too much risk in endorsing the option “paper” contracts associated with each option trade.

Sullivan and Knight were walking around Wall Street, pitching the “crazy” idea for a listed option exchange, based in Chicago. At the time, Model Roland was taking down some large positions on their block trading stock desk to facilitate institutional customers, and it was thought that an option market might provide the ability to hedge some of the unwanted risk in these stock positions. So, the firm instructed me to go out and buy a CBOE seat for $10,000. This was prior to the actual opening of the CBOE.

Each firm had to have a Registered Option Principal (ROP) who had to be an officer of the firm – I was an assistant vice president, and I was told “to take the test.” So, I took the test in 1973 before the CBOE even opened, and on day one, I was the ROP for Model Roland. Taking the test was what caused me to learn about options.

At the time (March of 1973), Model Roland was already having a terrible year in their proprietary trading account. I told my wife, Joan, that we were going to have a bad year as well. She said, “Well then why don’t you do something to advance your own career.” It was great advice, and I wrote an article for the legal journal, “Review of Securities Regulation,” regarding CBOE’s new rules options as it related to brokerage firms. The Journal accepted the article, and it was published in June 1973 and my article featured on the cover of the issue. I had previously sent the draft to the outside lawyers for the CBOE to make sure everything I said was legally correct. That article established a niche for me, and after its publication, got lots of calls from people seeking my advice!

A quick story: on Day one of CBOE trading, our firm received a call from a customer who wanted to do an option trade on the CBOE. The salesman said to me, “What do we do with this?” You have to understand that Model Roland was an institutional firm, and we did not have many retail accounts, but this was definitely a retail order. Fortunately, from what I had learned to become the ROP, we quickly opened an account and filled the order.

Ironically, even though Model Roland had bought the seat to potentially hedge their stock positions, the liquidity in the options market was not yet deep enough.
 

Q: Bill, when you and I first met, you were working for the American Exchange (AMEX). How did that come about?

Fixed commissions were about to be eliminated. The first to become “un-fixed” were floor commissions in 1974, and then on “May Day” 1975, customers commissions were also “un-fixed.” i.e. were fully negotiable. This introduced the era of discount commissions, and Model Roland realized that they couldn’t compete with firms such as Goldman and Solomon Brothers. So, they began to investigate selling the firm. I resigned at that time, because I didn’t want to stand in the way of what the older, senior partners wanted to do. They eventually sold the firm to Shields. The firm was called Shields, Model, Roland Inc.

At the time, there was a classified ad in the New York Times for a lawyer at the American Stock Exchange. I applied for and got the job. That was the fall of 1973.

Now, at the time, the AMEX’s niche in the stock market was that it had a large number of low-priced, fairly volatile stocks that were popular with traders and speculators. When they saw that option trading on the CBOE was also a low-priced trading instrument, the AMEX decided that it needed to be in the option business as well. They declared their intent to open a competing option exchange. So, the AMEX began trading options in January, 1975, with a completely different set of underlying stocks. There was no dual listing at the time. That was just 11 months after I had taken the job in the legal department. The big stumbling block to having two option exchanges was the clearing house operation. At its inception, the CBOE had created a central clearing house, called the CBOE Clearing Corp. That was one of three things that the CBOE had done to emulate the Chicago Board of Trade: 1) central clearing, 2) one-day settlement (which at the time was unheard of on Wall Street), and 3) the standardization of expiration for options terms and conditions, just like futures had (i.e., standard contact months, expiration date, and strike prices). There was some balking by the CBOE at the idea of a new clearing corporation, but the SEC insisted: they told the CBOE, “If you want to expand, you need central clearing,” and they told the AMEX “If you want to trade options, you need central clearing.” So, the Options Clearing Corporation was formed, and all options trades at both the CBOE and the AMEX (and eventually all of the other exchanges – Philadelphia, P-Coast, Midwest – that sprung up over the next few years) were cleared through the OCC.

Because I had written the article on options AMEX management asked me to help in the development of the options program and ultimately made me head of the option department. So, I left the legal department to run the Options Division. They also hired an option veteran from the old put-and-call dealer firm to handle strategy and option-oriented problems: Paul Stevens from Ragnar Corp. Paul eventually went on to become the CEO of the Options Clearing Corporation. This relationship worked out well for all of us, and I eventually hired Ken Liebler and Howard Baker, both of whom were very instrumental in running the AMEX’s options division.

But the Options Division was never recognized as a “full partner” with the stock specialists at the AMEX. Their mentality was that we were just a minor subsidiary of the exchange. Paul Stevens and I used to joke that we ran an “exchange within an exchange.” This was quite clearly illustrated when listed puts were first traded in 1977. It was a pilot program at first; not every stock that had listed call options was going to have listed put options. Each of the existing exchanges was given the right to choose five stocks on which calls were already traded on which to list puts; there would be 25 in all. So, we went to the specialist of one of our most active option stocks. We asked him if he wanted to have listed puts and well as calls. He basically said, “No, this whole option thing is a pain.” He was concerned with the complexity of puts and calls trading together on the same underlying stock. Such was the view of the old school stock crowd in New York; even after he had been making money being the specialist in the calls!
 

Q: Bill, it sounds like you were pretty set at that point. But I know you soon moved onto Chicago to become a senior executive of the Chicago Mercantile Exchange. That seems like a pretty big jump. Can you tell us about that?

By 1979, I was the number 3 person at the AMEX and had the title of Executive Vice President-Operations. Both of the people above me were much older, so I was on a career path to head the exchange.

Meanwhile, because of the creation of the OCC, each option exchange got one seat on the Board of the OCC. I was the AMEX representative. This worked out great, because I met several leaders of the Chicago financial community that I wouldn’t have otherwise known – Eddie O’Connor, David Goldberg, and Corkey Eisen, to name a few. All of them were well-respected people from the Board of Trade and were just great guys. This was really my first experience with the Chicago futures exchanges, and I realized that these Chicago guys were great to work with.

In the spring of 1982, a headhunter called and said that the Chicago Mercantile Exchange (CME) wanted to make me an offer¹. The CME had just signed an agreement with Standard & Poors to trade futures on the S&P 500 Index. Moving to Chicago was a tough decision for my wife and me, because our entire “universe” (family, business, and friends) was New York-based; and I had a very secure job at the AMEX. But, after serious consideration, I accepted the job, which was Executive Vice President and Chief Operating Officer of the Chicago Mercantile Exchange. That was in September 1982. Paul Stevens and Kenny Leibler got big promotions at the AMEX after I left. By June 1985, I was named CEO and President of the CME.

This was at a time when the CME was expanding greatly in the financial futures area, and they wanted to expand their option trading. It didn’t take long for Wall Street to figure out that these new S&P 500 futures were the best way to hedge big portfolios of stocks. The next year, 1983, the CBOE created its OEX Index, an index composed of the 100 largest stocks whose options were traded on the CBOE. That was a very popular option product, but there was no underlying instrument, so we started the S&P 100 futures on the CME. Later, the name of the product was changed to the “S&P 100" also. It was never as popular nor nearly as liquid as the S&P 500 Index futures, though, despite the huge volume in OEX options. The market makers just used the S&P 500 futures to hedge, for the products were quite closely correlated.
 

Q: That’s already a remarkable career at that point, but we all know it didn’t end there, for the biggest part was yet to come – at the CBOE.

Yes, I was at the CME from 1982 until 1997. Then Duke Chapman announced his retirement as Chairman and CEO of the CBOE. Duke had been the Chairman of the CBOE since 1986². They came to me to take over for Duke. It was another interesting decision. In my heart, I loved options, and my preference was always the “securities side,” so I took the job!

There were a lot of interesting, sometimes controversial, developments that occurred during the 20 years, that I served as Chairman – until 2017.

One of the biggest challenges was getting the floor to go electronic. The OM Exchange in Sweden had been the first to trying electronic options trading. Shortly after that, in 2000, the ISE (International Securities Exchange) began operations as the first electronic option exchange in the US and was taking away some of our volume. I was determined to keep our market share by going electronic as well. The problem was that the floor traders often didn’t see the bigger picture, preferring the less efficient (but more profitable to them) method of open outcry in a trading pit. Some of the floor traders said to me, “Give me two more years.” Meaning that they would retire by then, and they didn’t care what happened after that.

The debate got pretty heated, and there were calls for my ouster as Chairman. In fact, my opponents were passing out buttons that read “Brodsky must go.” My wife said, “Oh, they are wearing buttons with your name on it? I want one.” Dutifully, I went down to the trading floor and approached the guy handing out the buttons and asked for one. He probably considered me his enemy, but he gave me a couple of buttons anyway. A picture of each is shown here.

 

Bill, that’s a great story.

Well, there’s more to it. This was a serious, hard-fought argument. Seat owners who were leasing or renting out their seats were on the side of the floor traders. Many of the original seat owners were no longer trading, especially after the CBOE allowed seats to be rented. Renting was a big deal, with rents sometimes as high as 2% of the seat value, per month. The lessors – old-timers who owned the seats – were sympathetic to the floor traders. They thought that if we went electronic their seat rental income would disappear. Ultimately, we used the seats as a requirement to trade on the floor under the electronic system.

In reality, the CBOE had a floor-based electronic system, called RAES (Retail Automatic Execution System). But it only handled small orders. The point was that our customers wanted to see the market for an option and its size, so they’d know what size they could execute at a certain price. Eventually, the CBOE did go electronic, beginning in 2002. Now, all exchanges are electronic, of course.

But that wasn’t the last of my dealings with the ISE. The CBOE had exclusive ability to trade S&P 500 Options (SPX), just as the CME had the exclusive right to trade the futures.³ The SPX market was very popular with institutions and still is, and so the ISE sued us, contending that we should not have the exclusive right to that contract. The lawsuit went through seven different courts and appellate courts before finally being elevated to the Supreme Court of the United States. The Supreme Court decided not to hear the case, meaning that the verdict reverted back to that of the most recent appellate court, and the CBOE won the case. That was in December, 2013.

The other issue of major importance was taking the CBOE public. In this case, the CBOE members were with me, but there was a problem. In the original creation of the CBOE, the members of the Board of Trade had the right to trade on the CBOE. That right was a CBOE trading privilege attached to the BOT seat. In order for the CBOE to go public, we had to break that link between a Board of Trade seat and a CBOE seat. The link was officially called an “exercise right,” and the BOT members wanted to be paid something for that right. Eventually, it all got settled at the IPO. The BOT members got cash and stock but not the equivalent of a full CBOE seat.

There was another problem, with the seat owners who were leasing seats when we went public. There would be no more seats, so they were more concerned with what was going to happen to their rental income. So, even after we resolved the BOT Exercise Right issue, we had to come up with a hybrid model to give these seat owners some cash to make up for the lost money on seat rentals. Therefore, we threw in a one-time $100,000 cash as a “rental replacement” to each CBOE seat holder at the time of the IPO.

In the end, a CBOE seat was worth 80,000 shares of CBOE stock (which IPO’d at $29), plus $100,000 as a special (seat rental) dividend. So, at the IPO the shares alone were worth $2.32 million. The IPO took place on June 15, 2010. Today those shares trade at more than four times that price, plus the stock has paid a dividend for all these years!

In reality, a seat never traded for anywhere near $2.32 million before the idea of an IPO started to become reality. When I first got to the CBOE, a seat cost about $200,000. When the CME had gone public, groups of investors had bought seats in advance of the IPO and done very well. The same thing was going on with the CBOE IPO. These same investors were buying seats and paying record prices, right before the IPO. We were the last major exchange to go public, since it took so long to resolve the electronification issue, and the “exercise right” issue with the CBOT.
 

Q: The CBOE has certainly been an innovator of new derivative products? Which of those stand out to you?

Well, of course, the CBOE invented Index Options on the OEX in 1983 and created VIX in 1993 (with the assistance of Professor Robert Whaley from the Fuqua School of Business at Duke University). Those were before I came on board. Then, in 2003, the calculation of VIX was changed to begin using our proprietary SPX options rather than the OEX options which had been the basis of the 1993 calculation. Another innovation was LEAPS options, introduced in 1990. These are long-term options on various stocks, and one of the marketing slogans was “Why buy a stock when you can rent it?”

One aspect that I thought we did a good job with was the creation of tradeable products on VIX. That came about in 2004, when VIX futures were listed (VIX options began trading in 2006). When traders first came to us and said that they needed to trade futures on VIX, we knew we needed a futures exchange to trade them on. So, either we traded them on the Chicago Merc (CME), for example, or we created our own futures exchange. We decided to create the CBOE Futures Exchange (CFE) in order to trade the VIX futures, and that turned out to be one of our smartest moves. But then how do you clear them? We decided to clear through the OCC.
 

Thanks for a terrific interview and your insights in the workings and history of the options market.

[Editor’s note: Today, Bill remains active in the firm, Options Solutions, which he founded along with his son Michael, Steve Sears, and Bill Speth. Also, In January 2022, President Joe Biden nominated Bill Brodsky to serve as a director of the Securities Investor Protection Corporation (SIPC) – a post which he still holds at this time.]
 

Ed
Tilly

Chairman and Chief Executive Officer, CBOE Global Markets

 

Interview by Lawrence G. McMillan, 4/20/2023

Ed Tilly is the current Chairman and Chief Executive Officer of CBOE Global Markets, after having taken over from Bill Brodsky as CEO in 2013 and Chairman in 2017. Ed began his career as a stock clerk on the CBOE trading floor in 1987, then became a member as a market-maker in 1989, before electing to move into CBOE’s “front office” full time in 2006. I spoke with Ed recently to get some of his thoughts on his career at CBOE.
 

Q: Ed, how did you get started in options in the first place?

Right out of college, I was considering several different options, but ultimately pursued an open stock clerk position with Steve Fossett’s¹ trading business. I thought it would be a terrific opportunity to learn the business from the ground up. I took it and started on the CBOE floor in 1987, taking stock orders from market-makers and phoning them over to Fossett’s stock desk.

Fossett had always been an early pioneer in trading technology. He had one of the first DOT machines (Direct Order Transfer) that would send orders from CBOE to NYSE. I was working for Tom Asher, who would later become a Vice Chairman of the exchange and also serve on CBOE’s Board of Directors.

In 1989, I became a member as a market-maker and was making markets in the Texas Instruments (TXN) trading crowd at that time. Incidentally, Texas Instruments was one of the original 16 options CBOE listed on opening day in 1973. When the exchange went to the Designated Primary Market Marker (DPM) system a few years later, I was awarded DPM for a group of options, including Texas Instruments and Qualcomm (QCOM).

I’m really grateful for those years, learning the business from Steve. His successful career has been well-documented. He was a true visionary and had trading acumen that few could rival. He was a phenomenal market-maker. That experience really helped shape the early part of my career. And I was not unique. Steve backed hundreds of traders who would go on to make a mark in our industry. Steve’s impact was profound – he was one of the true pioneers that really helped make the U.S. options industry into what it’s become today.
 

Q: Did you enjoy your time on the trading floor?

Yes, I really did. In those days, what was so exciting about the trading floor was the atmosphere. It was like a pro sporting event every day. The energy, the enthusiasm, the competition. Every day was game day and you needed to be ready to go when the opening bell rang to vie for trades. In those times when there was a lull in the action and trading slowed down, that competition would extend into other side activities like how many White Castle sliders could someone eat? Regardless of what was going on in the market, and whether trading was busy or slow, that competition never went away. It was a constant every minute you were on the trading floor.
 

Q: When did you realize you wanted to make the move to be “upstairs” – in the front office?

My first experience with exchange governance was working closely with Bill Floersch, who was CBOE’s Vice Chairman at the time. As a member-run organization, CBOE had several membership committees that worked with the Vice Chairman and exchange staff on running the exchange. I was still a trader on the floor but began to get more involved with the membership committees, learning the business side of the exchange. I served on a variety of committees during my time on the floor. I chaired the Equity Floor Procedure Committee from 1998 through 2002, which was a pivotal time for the exchange as electronic trading began to transform the options industry. Our committee worked alongside CBOE’s operations and technology teams to lead CBOE’s charge to create and implement our hybrid trading model – which blended the liquidity and price discovery of open outcry trading with the speed and efficiency of electronic trading. Our trading floor housed a tremendous liquidity pool – it still does today – and for us, we wanted to continue to leverage that as best we could, so the hybrid model incorporating the “best of both worlds” was the direction we pursued. We launched our hybrid market model in 2003 and today, our CBOE Options Exchange continues to use that hybrid model. Of course, it has evolved and been enhanced over time.

I also served on the Board of Directors twice as a member director – first from 1998 to 2000 and then again from 2003 to 2006. When it became apparent that the technology race was going to continue, Bill Brodsky (who was the CBOE Chairman and CEO at the time) offered me the job as Executive Vice Chairman of CBOE in 2006. Given my background as a trader and experience working on the Equity Floor Procedure Committee, the role, which included new product development along with a focus on further enhancements to the hybrid trading system, was a natural fit. This was a newly created role on the executive team that enabled me to work closely with Bill and the incredible executive team and our member-elected vice chairmen. So, I left the floor and made the move “upstairs” to the executive suite. During those first few years, we continued to enhance our technology and bring new products to the marketplace, including VIX options in 2006.

I was incredibly fortunate to work with Bill Brodsky for as long as I did and so pleased that we still keep in touch. He was a mentor to me. He was incredibly generous with his time, and his passion for our people and our business was infectious. He was a tireless advocate not only for CBOE, but for the entire industry. A titan in the U.S. options industry.
 

Q: Things seemed to happen fast after that. Can you give me a summary or share a couple of highlights?

Well, one major highlight was that CBOE went public in 2010. We demutualized and moved away from a membership-run organization into a publicly-traded company. We hosted our IPO ceremony on the CBOE trading floor. At the time, we had just begun renovating the trading floor as we were reconfiguring some of our trading pits. VIX had outgrown its first pit on our floor and we were getting ready to move the VIX pit into the larger OEX space. So, before we did that, we thought we’d modify the OEX pit to host the ceremony. Our building engineers did an amazing job to pull that off and the morning of the ceremony, the pit was jammed with members, staff and other VIPs. CBOE IPO’d that day at a share price of $29. And the VIX pit moved into its new home a few months later.

[Editor’s note: Each CBOE seat was converted into 80,000 shares plus a one-time dividend of $100,000. So, the initial seat investment of $10,000 in 1973 would have been worth $2.42 million in 2010 – a compounded annual return of almost 15%.]

Getting to that day was not easy, however. CBOE was founded out of the Chicago Board of Trade back in 1973 and upon our opening, some CBOT members had what was called the “exercise right,” which granted them the ability to trade at CBOT and CBOE. When it became time to convert CBOE seats into shares of CBOE stock, those CBOT members felt their exercise right entitled them to receive CBOE shares. This tied us up in the courts for several years while many of our peer exchanges went public. Once resolved, we were finally able to proceed with our public listing and IPO.

More recently, over the last several years, we have been aggressively building CBOE’s business through acquisitions that have expanded us into new assets classes including equites, FX and digital assets and into new corners of the globe, including Canada, Europe, Australia and Japan. We’ve gone from a Chicago-based options market to a global exchange operator with 26 markets around the world, in multiple asset classes.

The vision and entrepreneurial spirit of our founders is alive and well and is still a big part of us today. The next 50 years should be just as exciting as the first 50.

[Editor’s note: Ed Joyce had been CBOE’s President and COO. When Joyce retired in 2011, Ed Tilly was appointed to those roles. Then, in 2013, Bill Brodsky stepped down as CEO, while still retaining his title as Chairman of the Board. Ed took over as CEO in 2013 from Bill. Then, in 2017, Bill retired completely, and Ed also became Chairman of the Board.]
 

Terrific career, Ed, keep it going!

Joe
Doherty

Co-Creator and Director, Chicago Board Options Exchange

 

Forward by Lawrence G. McMillan

I would highly encourage anyone who is going to read this article of Joe Doherty’s recollections, to first read the article by Joe Sullivan. Joe Doherty was extremely instrumental in the creation of the CBOE, for he worked right along with Joe Sullivan as the process inched forward for four years before the exchange was born. These are some recollections that Joe D has of those years and the ones that immediately followed.
 

After re-reading Joe Sullivan’s paper about the 4-year gestation period of the CBOE, I was reminded what an excellent writer he was and how completely he had covered the CBOE’s formative years. So, what I am going to add are just a few personal recollections from that time period. I will, at times, refer back to what Joe has said.

After college and graduate business school, I was completing an Army hitch. A couple of Army buddies and I had dabbled in commodity futures trading. This whet my appetite for doing something in the financial world. In the spring of 1969, I read in the Wall Street Journal that the Chicago Board of Trade (CBT) was investigating getting into options. I had little understanding what this meant, but I decided it sounded like it might be fun as something with which to try to get involved after my army days ended.

I struggled with how to sell myself, but after enough bourbon I finally produced a letter I sent off to the President of the CBT, which I imagined to be some huge monolith of an organization. In fact, the CBT organization was more like a large 4-H club, as that had been the source of many of its presidents. But it was in the process of a significant change of focus, and had a new President experienced in the ways of Washington politics. He passed my letter on to his speech writer and head of research – Joe Sullivan. To my surprise, Joe called me and invited me to Chicago for an interview. To my even greater surprise and delight, Joe subsequently offered me an ill-defined job working with him to explore getting options trading going at the CBT.

I was the second hire by Joe Sullivan (Barbara Kaplan was the first) and started in July of 1969. At that early date, the thought, reflected in a PERT chart, was that it would take about six months to get everything in place for trading to begin. We severely underestimated the magnitude of the project, especially the regulatory requirements that would have to be addressed. For more than three years, the PERT chart never changed – we were always still six months from launch.

One of the first tasks was design of the options contract. With the benefit of hindsight, this seems trivial. But more than 50 years ago there was no roadmap whatsoever, so all avenues were explored. For example, one alternative that was considered for a while was to fix expirations and the premium and then trade the striking price. Today that sounds bizarre, maybe even stupid, but it was seriously explored before being dismissed.

Elsewhere, Joe Sullivan chronicles what meetings with the SEC were like in the early days. One vivid memory I have was sitting in the office of the long-time Director of the Division of Trading in Markets. At one point he said, “Heretofore, options have been like a fly buzzing around in my office. I can ignore a fly. You guys are proposing to turn the fly into a buzzard, and I can’t ignore a buzzard in my office.” Fortunately for the CBT’s developing plans, the pre-eminent securities lawyer in the US, Milton Cohen, was located only a block away from the CBT building in Chicago. After careful consideration, Joe convinced him we were proceeding in a responsible manner, and he agreed to represent the CBOT on the project. Milton’s gravitas was such that his addition to the team meant the SEC would no longer dismiss us out of hand. That is not to say it became a cakewalk. For the next few years, the SEC continued to raise questions at every turn. At one point they produced a list of, I think it was 50, multi-faceted questions that required written responses. If they thought Joe and Milton might fold the tent, they were mistaken. The two of them and Burt Rissman and Mike Meyer, two colleagues of Milton’s at Schiff Hardin, went to work on what was dubbed “The Spring Term Exam.” Eventually all the questions, and many more that came subsequently, were satisfactorily answered, and the CBOE was allowed to commence trading. Looking back, I now think the deliberate pace dictated by the SEC might not have been all bad. Absent the delay and some of the requirements imposed by the SEC, the exchange likely would have opened sooner, and been less prepared. Then some early glitch or blow-up might well have permanently doomed the venture.

While Joe and the legal team were sparring with the SEC, my primary role was to work with the “Securities Committee”, a group of Board of Trade members charged with designing the trading/order execution rules and procedures. At that time, securities exchanges assigned unitary “Specialists” for each stock, while the commodities exchanges had competing “Floor Traders.” Both of these roles harbored an attendant conflict of interest, because an individual was not entirely precluded from acting as both broker (or agent on behalf of customers) and dealer (or principal for a personal account). The SEC was not enamored of the presence of this conflict.

Some of the committee members also thought a combined broker and dealer role harbored conflicts. Under the direction of its chairman, Irwin (Corky) Eisen, the committee decided to take the bold step of completely severing the broker and dealer functions. Again, see Joe Sullivan’s description of the resulting roles. A fundamental principle of the CBT (and other commodity exchanges) was that the best markets resulted, and customers were best served, when orders were exposed to a group of competing traders, each acting in his (only a few women in those days) self-interest. In contrast, the SEC believed a trader’s privileged position on a trading floor had to be earned by fulfilling “affirmative obligations.” I was the scribe for the committee’s long discussions trying to reconcile these two views, and I dutifully wrote up at least four fully fleshed out, but different plans. Each plan covered what were Chapters 4, 5, and 6 of the CBOE’s rule book. It may seem hard to imagine, but I spent an entire working year of my life attending committee meetings, long discussions, and drafting and redrafting those chapters. Finally, the Exchange filed and had approved the fourth iteration, which did include affirmative requirements for market makers.

When trading began, I left the employ of the CBOE and became a trader on the floor.

Who came to the unproven exchange at its outset? I recall two categories of people who made up the majority of the early floor population. The first category was populated by young people looking to get a start. Some had been clerks or trading environment operators elsewhere. Others were pretty fresh out of college, and often directed to the CBOE or sponsored by a father, uncle, or friend on the CBT. The second category of people were those looking to restart a career, generally meaning they hadn’t done well in the previous one. Not true in all cases, of course, but my summary take is that most of those who had not done well before, also did not do well on the CBOE. But enough of the young people thrived and prospered that the CBOE succeeded.

I’ll mention a few of the things that stand out for me from the early trading days of the exchange. In doing so, I won’t repeat the thoughtful recollections Michael Greenbaum has posted about that period. I agree with him that high margins deterred public option writers and resulted in high prices for options. Also contributing to wide spreads was the fixed commission structure of stock trading, which hampered hedging by market participants. Unless you were a member of the NYSE, you had to pay high, fixed commissions to hedge your option positions. I remember paying over $.50 per share to trade Upjohn stock! Fortunately for the development of the CBOE, and for unrelated reasons, the SEC mandated the end of fixed commissions on exchanges on May 1 of 1975.

One feature of the CBOE that was new for almost all participants, even those with previous trading experience in commodities, was that options were derivative instruments, the values of which were linked to the prices of the underlying stocks. In some primary markets, particularly thinly traded ones, if a trader was, say, short a particular instrument, he might sell more in an effort to move the price in his favor. Obviously, that approach would not work in options. On one occasion, when IBM announced good earnings and the stock moved up sharply, a commodity trader, known as the “chicken king” because of his large role in the trading of iced broiler futures, apparently tried it. He was short call options, and although the stock had moved up sharply, he kept selling more at the previous day’s price – until he was carried away.

Since the Black-Scholes formula and the start of options trading arrived on the scene at almost the same time, it didn’t take too long for some traders, both on and off the floor to begin using it. But the first iterations, before the advent of hand-held devices or portable computing, were clumsy to use by today’s standards. Fischer Black, then at MIT, for a fee, provided an option pricing service. I was an early subscriber. The service consisted of a thick monthly mailing of hard copy price tables – a different set for each week for each stock, if I remember correctly. Values were based on Black’s volatility estimates and, also at volatilities 10% higher and 10% lower. Values were shown at incremental prices of the underlying stocks. So, if it was, say, Wednesday, and the stock was at 48½, one had to calculate an options value by interpolating between values at underlying prices of 48 and 49 for that week and also for the next week. And then you had to further interpolate between the two weekly values. Rocket science was not required on the part of the user, but the ability to do arithmetic on the fly was a useful skill.

Another thing Michael Greenbaum said was that the CBOE was lucky there weren't any big swings in the stock market in the early going. I agree. The first bull market I experienced I think was in early 1976. One of the stocks I traded was Hewlett Packard. On the day before the market rocketed up, an out of the money option series that I was short had closed at 3/8 of a dollar. (Decimal pricing didn't arrive until sometime later.). The next morning, that particular series opened at $ 3/4. I was licking my chops and took "advantage" of the opportunity to short more of the options. (At that time, each option series for a given stock was opened one at a time, and after an opening price was established, an option series couldn’t be traded again until the “rotation” for all series in that stock was completed. This could sometimes take 15 minutes, depending on how many option series were trading on the stock) After the opening rotation was completed, the next price for that series was $2.00 bid! Of course, all other call option prices were soaring, too. It was a painful lesson for me, and worse for some others.

I think the initial rules governing floor activity generally functioned pretty well. As the Securities Committee had hoped, the affirmative obligation of market makers to provide two-sided quotes of prescribed maximum width was not often invoked. Competition among traders almost always produced narrower quotes.

Other rules of chapters 4, 5, and 6 did need some changes as the marketplace evolved. Independent floor brokers, a hallmark of commodity exchanges, and member firms, seeking to maximize the use of in house brokers, were at odds. And market makers and “upstairs” traders clashed over the shopping of orders off the floor and the crossing of pre-arranged trades. Some of the clashes got pretty acrimonious.

For four of the early years, I was on the Board of Directors. Board members were elected in designated categories so that the “floor,” which held the preponderance of exchange memberships, wouldn’t dominate the member firms on the Board. I was a “floor director.” Another director at that time was Bob Rubin, a youngish partner at Goldman Sachs, who represented the upstairs traders and arbitrageurs. I like to think Bob and I tried to operate as moderating influences for our respective constituents. At times, though, moderation failed. I vividly remember one incident. A group of traders had come from New York to meet with market maker representatives. The meeting took place over dinner at Chez Paul, then a sedate restaurant located in an old mansion. When I arrived at the restaurant, I started to ask the receptionist for the location of the private room. She waived to the stairs and said, “Upstairs, just follow the noise.” To put it mildly, the meeting was raucous. At one point an attendee, who shall remain nameless, stood up and screamed across the table at another: “You never were anything but a fucking chicken-shit.” No matter where one was in the restaurant this was heard clearly.

Not that evening, but at other times, moderation generally prevailed. Eventually a truce was negotiated between the warring sides, and the CBOE marched on. Bob Rubin eventually became Secretary of the Treasury during Bill Clinton’s Presidency.

After more than a dozen years on the CBOE floor, I accepted an opportunity to join the options trading firm, O'Connor and Associates, where I was part of a team that developed a global FX option business. A few years later O'Connor linked up with Swiss Bank, which later merged with UBS. I spent seven years, primarily in a risk control role, first in Basel, Switzerland and then in London. I would sometimes stand on the periphery of the bank's large London "dealing room" and observe the activity. The room had many Americans and Brits, of course, but there were also traders and marketers from every continent and many, many countries. This polyglot was a constant buzz created by some who were trading and some who were servicing global customers in a wide variety of derivative products. The 911 contracts traded on Day One of the CBOE has grown to 10 million contracts per day, or whatever the number is now. On that basis the CBOE has been an incredible success. But those numbers, alone, fail to reflect the broader role, which the London dealing room evidenced -- the CBOE kick-started a revolution in global finance. Amazing!

I retired, now almost 20 years ago.

-- Joe Doherty

Jim
Dalton

Marketing Director, Chicago Board Options Exchange

 

Forward by Lawrence G. McMillan

Jim Dalton was the first Marketing Director of the CBOE, and he was hired by Joe Sullivan to put together the marketing team for the exchange. As Joe Sullivan wrote in his recounting of the era (be sure to read that recount as well), “Jim Dalton...built the best marketing team assembled at any exchange in that era if not ever.”

Personally, Jim is important to me (your editor) because when the head of the New York Institute of Finance was looking for someone to write a book on option strategies, he contacted Jim Dalton, among other people. Jim told him that there was some young guy at Thomson McKinnon that was writing about option strategies and suggested that the publisher contact me. He did, I submitted a long 35-page outline, which was accepted, and that’s how Options As A Strategic Investment was born.
 

I was running the Institutional Options Department for Paine Webber in 1973 when Joe Sullivan hired me to lead marketing for the CBOE. I was a member of both the CBOT and CBOE and had to relinquish both memberships once I became an official employee.

My first task was assembling an exceptional team: Ivers Riley, Dan Skelton, and Jim Emerson. We truly were a team. When we would travel we were known as “the CBOE”—people sometimes called us by the wrong names, but that was okay as long as they knew we were “the exchange.”

I only remember one time when we weren’t in complete agreement, when listed puts began trading in 1977. There was momentum behind explaining puts as merely being the opposite of calls, addressing them as their own vehicle. But we insisted that the focus should be on strategies that employ puts and calls. In the end, this was the approach we used, and it was successful.

When we were on the road, my market presentations were generally well-received. I never spoke from a prepared script, instead opting for more informal, interactive sessions with retail brokers (which I had been, at one time). Joe Sullivan, on the other hand, came from the more formal world of the Wall Street Journal, where he had been their “man” in Washington, DC. Being the super-intelligent guy he was, he would meticulously compose his speeches, which resulted in a rather dry delivery. While I was a better communicator with brokers, Joe was the guy who got things done with the regulators and the Board of Directors, which was extremely important. One time he got a tape of one of my presentations and said, “Jim, these aren’t even complete sentences you’re using.” He didn’t always understand my more colloquial style.

In the early days, there was a great rapport among the original CBOE staff —just 15 or 16 of us, initially. We spent many an evening at The Sign of The Trader bar after work, building the camaraderie that had a lot to do with the success of the exchange. Joe Sullivan didn’t usually “attend” these after-work sessions, but he was the one responsible for the whole operation.

Working for the exchange was a difficult job; brokerage firms, exchange members, and institutional traders always thought they had a better idea for how to do things. But Sullivan kept it all together. He was smart, and he was able to work with diverse groups to build consensus and move forward. That takes a unique temperament.

Joe was so bright that he would sometimes complete a thought in his head, but not actually say it out loud—although he might have thought he had. He’d talk to staffers and dismiss them without specifying what he wanted them to accomplish. On more than one occasion, I was approached by someone after they met with Joe, and they’d say, “I’m not sure what I’m supposed to do.” I’d tell Joe that, and although he wasn’t too happy to hear it from me, he’d get the situation cleared up straight away.

When I was hired to head up marketing, I had one mission in mind: to generate enough new business that market makers on the floor could actually “make markets.” That sounds obvious, but these pivotal market participants needed order flow for liquidity. There was much attention on volume and open interest, for in the early days the size of bids and asks wasn’t disseminated. I knew institutions weren’t going to be big players right away, so we concentrated on retail firms, controlling their marketing by creating and printing targeted pamphlets on which they’d put their own logos—it looked like this information was coming from each firm, but the content was from CBOE so we could shape a consistent, compelling story for the public. In total, we probably put out about 12 million pamphlets, maintaining control of marketing messaging for several years, which helped facilitate our growth.

The institutional business came on gradually. Goldman was in early because of Bob Rubin; they used options for arbitrage and hedging. Oddly enough, the institutions wanted to see volume before they were willing to trade volume—a Catch-22. Within a year, we were doing more transactional business than the NYSE. Of course, we’re talking about number of contracts, not total trading dollars. We made that information known to institutions as well.

We couldn’t expand the business to insurance companies without a lot more work. Various states all had different insurance laws to allow for option writing. One of the first to agree was New York State. They were relatively knowledgeable and worked with us to write regulations that allowed insurance companies to sell covered calls against their portfolios. Soon after, a Chicago newspaper picked up the story and wrote that they were now allowed to buy calls. That was a bit embarrassing because that wasn’t what the regs said at all, but the New York commissioner laughed and said “Don’t worry about it.” Perils of new products.

Soon after, we went to Austin to meet with their top regulator to see if we could get similar rules written for Texas. We sat down with the chief examiner, an appointed official who knew nothing about options. He started spouting off about how he’d been in this job for 25 years, had a wife, two kids, and a mortgage, and we wanted to “talk nonsense.” But our lawyer knew the chief examiner from his days as chief council for Prudential Insurance and said, “Your problem is you brag too much.” Fortunately for us, everyone laughed and we left with the assurance that we would get our regulations written. We all pitched in to tackle whatever was needed in those early days, from keeping up with growing volume to managing relationships with regulatory bodies, which as a young exchange was extremely important. At one point the SEC asked for a feasibility study regarding “the efficacy of options.” Joe Sullivan hired a consulting firm to produce the report, which said exactly what we had predicted—that options wouldn’t work because they had always been such a small market. It was clear they simply didn’t understand the new concepts, especially the severing of the link between the buyer and seller of an option through the use of the Clearing Corporation. Breaking this limiting link was what made options fungible, leading to the rapid expansion of the options market.

The old put-and-call dealers in New York (I believe there were 22 of them when the CBOE was created, most of whom turned down the opportunity to buy a CBOE seat) had always operated with that direct link between buyer and seller. It was a clumsy, non-standardized market, with virtually no secondary market. Some New York people understood, though, and tried to bridge the gap. That gave some legitimacy to the new exchange with the old New York crowd.

After the AMEX created the first dual listing in National Semiconductor in 1977, there was intense competition for order flow. Then five more stocks were dually listed. Merrill Lynch, for example, said they would send their order flow to the exchange with the most volume. We all figured that success was going to be dependent on firms like Merrill and where they sent their order flow. That’s why I created a “scoreboard” that compared AMEX and CBOE volume. Dick Cowles mechanized the idea and created a board that showed information on both the CBOE floor and the CBT floor. Since CBT members could trade on the CBOE, there were times when they’d see the AMEX volume jump ahead, so some would come over to the CBOE to trade heavily, pushing the CBOE back ahead. When the SEC became concerned, I jokingly said, “It was Dick’s idea.”

It's interesting to look back at the origins of a market mechanism that has become so fully ingrained in global risk management. Joe hired me to head up marketing, and the storylines my team contributed helped get options over the hump, so to speak, and I really enjoyed the work. We brought lifeblood order flow to the floor, which attracted institutional business and successfully positioned the exchange. The rest is history.
 

Editor’s note: Joe Sullvan, Jim Dalton, Ivers Riley, Dan Skelton and Jim Emerson were reunited a few years later in forming The Options Group, an institutional consulting firm.

Ed
Kelly

Floor Broker on Day One, RW Davis; Goldman Sachs

 

Forward by Lawrence G. McMillan

Ed Kelly was one of the original floor brokers on the CBOE from Day One. He served on many important committees and was a stalwart at the Exchange. Joe Doherty – whose own recollections are posted elsewhere on this website – had this to say about Ed: “ He was the consummate professional from the moment he stepped on the floor. I very much liked his appreciation of what the early CBOE was, his recognition of what it could become, and his willingness to work with that long term potential in mind. This at a time when many of his contemporaries, in the early days, viewed the trading floor as a candy store from which they should grab as many sweets as fast as they could.”
 

Bob Barr and I were employed by Ralph W. Davis (RWD) a floor broker at the Midwest Stock Exchange, and the firm asked the two of us to start a floor operation on the CBOE. RWD bought two CBOE seats prior to opening day. Ralph was planning to spend more time at the Chicago Board of Trade (CBT) trading grain, so we ran the CBOE operation from day one.

My only experience with options prior to the CBOE had been when a customer had wanted to trade some puts and calls, over-the-counter. I didn’t know what they were at the time, but found a book published by Filer Schmidt, one of the put and call brokers in New York. That was my first experience with options.

We met Ralph Goldenberg from Goldman prior to CBOE exchange opening and offered to help him with order flow. Goldenberg was trading grain on the Board of Trade, and he set up a simple floor operation on the CBOE, with a couple of clerks running orders out for Goldman.

Bob Barr and I were handling the order flow of a number of New York firms. For example, we received Leon Pomeranz’s business from Pershing, because when RWD needed to execute stock in New York, they would use Pershing. But primarily we were handling the Goldman Sachs order flow. Later, I met Bob Rubin (from Goldman), since we served on some Committees together at the CBOE, and he was on the Board of Directors of the CBOE. Eventually, Goldman grew to the point where they wanted a full-time operation on the CBOE. Bob Rubin said to me, “Why not come over and run it?” By that time, I was spending more time on Goldman issues than RWD, so I said yes. That led to a long-lasting relationship.

The CBOE was on “pilot” for 6-7 years; we couldn’t do anything until the SEC approved it. I remember that being a burden, but eventually that passed.

I was head of the Floor Procedures Committee for a spell. And then after that, I was on the Business Conduct Committee for many, many years. About 15 years ago, they asked me to rejoin the committee as a “Public Representative.” I’m still on the committee in that capacity. This probably makes me the only person present on Day One, who still has an official exchange role 50 years later!

We saw a lot of cases on that committee. One that was pretty funny, in retrospect, was when we were investigating the trading in a particular stock, and one of the market makers had been involved in it. The market maker showed up with all his lawyers, and they reportedly told him not to say anything. But they did put him up as a witness. The problem trading occurred when the stock gapped opened up about 8 dollars higher and then was halted for trading. He had put in a big buy order right before the halt. He was asked, “Why did you put in this big order right after it opened?” Although he had been instructed not to say anything, he responded “To stop it from trading!” (Supposedly so that he could get a handle on his positions before prices started moving all over the place). His lawyers jumped up and wanted the statement stricken from the record, but it was too late. The lawyer eventually would up throwing a fit and slamming his books on the floor.

As a trader, it was common in the early days to see some of the CBOT traders wander on the CBOE floor and want to trade. There some real characters. Some came wearing fedoras and smoking cigars. A lot of the time, they didn’t know the rules or even understand the market maker system. They’d come out to the floor not knowing what an option was. So, we decided that we needed a program to initiate these people to the rules. I created a fairly simple test that these members had to pass before they could trade on the CBOE.

That was fine for some traders, but the veterans on the CBOT weren’t going to take a test. One was a venerable and very successful trader named Frankel. He was pretty old, and all he wanted to do was trade on the exchange; he wasn’t interested in taking any test. His friends finally talked me into giving him the test orally, and he agreed to it. So he came up for coffee, and I gave him the test. He passed and said, “Sonny, I was writing puts and calls before you were born.”

I was just afraid the guy was going to lose all his money. As one CBOT trader put it: “he can’t lose all his money” (implying he had so much). Out of gratitude, he offered to let me ride along on one of the most profitable trades he did annually. It had to do with the fact that he could tell when the thaw was going to come on the Great Lakes by the way the grain futures traded. And he would then trade spreads to make a lot of money as grain deliveries by ship began to expand. I didn’t want to do that, because I wasn’t sure it was legal. But later on, I was talking to Eddie O’Connor, the famous Board of Trade member who was instrumental in founding the CBOE. Eddie said to me, “You did it, didn’t you?” The Board of Trade was its own world!

Another interesting case shows just how wide open things were in the beginning. They were rules, but they weren’t often understood or followed. Right after the exchange first opened, an ad appeared in the Chicago Tribune stating, “Own General Motors and get an immediate cash dividend.” It was run by a salesman for a wire house, and it was referring to writing a covered call and getting the premium immediately. There were a couple of problems there: 1) salesmen for wire houses can’t run their own ads; they have to be approved up the line at the firm, and 2) the ad title was pretty misleading – at least for what was allowed back them. You have to give him credit for trying something new, but it didn’t work. You really couldn’t do that. He was fired and the ad was pulled.

Later there was a fire at CBOE and a lot of records were burned. They asked for any records, exchange memorabilia, anything that you had and wanted to contribute. I turned everything over I had: committee minutes, case work, etc., or I could probably relate a lot more stories.

All in all, it was an incredible time because everything was so new and was changing rapidly. For the most part, everybody was helpful to each other, and that’s what really got the new exchange going in the first place.

–Ed Kelly

David
Lucterhand

Managing Director, MarketGrader Capital, LLC

 

Interview by Lawrence G. McMillan, 2/3/2023

I met David Lucterhand when we were both freshmen living on the same floor in the H-1 Dorm at Purdue in the fall of 1964. A few years later, on my first visit to the CBOE – in November of 1974 – I was on the small trading floor in the old smoking room. To my surprise, there was David Lucterhand, making markets on the CBOE. I called David this week to get some of his remembrances of the early days:
 

Q : So, David, how did you come to be a market maker on the CBOE?

I started out to be an engineer at Purdue in Astronautical Engineering (a part of Aeronautical Engineering). That lasted about three weeks when I realized that wasn’t what I wanted to do at all. It was especially disappointing because I had turned down an appointment to the Air Force Academy to go to Purdue. So, I went to see the Dean of Freshman Engineering for some counsel, and after talking for a while, he said that what I wanted “sounds like Political Science.” I agreed, and he admitted that Purdue was not well-known for that major but that they had recently beefed up the area, and he set up meetings with the Dean of History, whose department contained the Political Science major. Ultimately, I had a great experience and stayed to get a BA with a dual major in Modern European History (1815 +) and Political Science. While at Purdue, I read a book entitled The Pit, by Frank Norris. It is a novel (written in 1903) and relates a story quite similar to the movie “Trading Places.” After that, I was intrigued by the grain markets and wanted to get into the business. After working in several jobs and attending graduate school, I saved what I thought was enough money to buy a CBOT seat and I was ready to start the membership process. However, at about the same time, Russia suffered a poor wheat crop, and started buying up wheat all around the world. That had the residual effect of sending CBOT seat prices soaring and I could no longer afford one. Upon further research, I found out that a CBOT seat had the residual rights to trade on the CBOE. Furthermore, CBOE seats could be leased. By this time, it was late 1973, and I had a job that allowed me to be free in the afternoons.

Through friends, I was able to get Guest Passes to the CBOE and stand in the crowd – a sort of “paper trading under fire.” I tried to realistically estimate which trades I would have taken, how much of the trade I would have gotten, and what my paper profits would have been. Even allowing for the “slippage” of doing this on paper, it seemed like a very profitable venture. I was making (again, on paper) my current annual salary in a month or two. So, I leased a seat on the CBOE and began trading.
 

Q : What do you remember about trading on the CBOE?

The CBOE did not have designated stocks that the market makers had to be present in. But I mostly made markets in Xerox, IBM, Teledyne, and Northwest Airlines and, really, quite a few others.

I cleared through Goldberg Brothers. All positions were kept on paper (there were no handheld computers at the time). Out-trades were always a surprise and sometimes a problem. Mostly you found out you had an out-trade when you got your position sheet in the morning from Goldberg and it didn’t agree with your own records. That could make you long or short something you didn’t want. Personally, I tried to go home flat each day. Not everyone did, though. 1973-1974 was a bear market (the DJ Index hit a low of 577.60) and there was one trader who was notoriously short. He often stood next to me in the XRX pit. One day, David Goldberg came down to the floor and whispered something in the ear of that guy. I asked him what Goldberg had said. He said that Goldberg told him “they also go up.” It was Goldberg’s way of saying my friend should decrease the size of his short position.

I got to be a relatively large trader. You could tell how much you traded by the size of your Christmas present from Goldberg. I always did pretty well in that regard. Later, when I added the CBOT seat, I cleared Goodman Manaster. They also made a lot more money clearing my trades and I remember the Christmas presents were even bigger. I also remember selling calls on NWA almost every day and making money. It got to the point that I wondered they could afford to keep their planes flying when I saw them in the skies over Chicago. They had distinctive red tails.

There were a lot of stories. I remember one guy – we called him “Turtle.” He was a tall guy and always wore a fancy tie knotted tightly at the neck. He was prevalent in IBM and was always saying things like “Sell the ‘80's, get a Mercedes.” He had limit short positions on in just about everything. Eventually IBM exploded to the upside, though and he got buried. But the old adage was that if you were going to lose, lose big. In this guy’s case, they made him a partner at his clearing firm!

I think the thing I remember the most about the floor, though, was the camaraderie among the market makers. There were lots of social bonds, and they were every bit as strong as professional bonds on the floor. Since we all shared risk, it was sort of like being in battle together. Of course, there was competition for orders, but the floor brokers tried to allocate as much as possible to each trader if the bids were comparable. I never had any negative experiences in that regard on the floor.
 

Q : You mentioned the CBOT. How did you get to that floor?

In 1976, the CBOE expanded to a new floor. There was a big deal, black-tie affair for that opening. But the intimacy was lost. The floor went from being a club to something much less intimate and less familiar to me. I traded on that new floor for a couple of more years, and then decided I wanted to pursue my original objective of owning a CBOT seat. I bought the CBOT seat in 1978 (having converted my CBOE lease into a CBOE membership). I then sold the CBOE seat for the CBOT seat. Since the CBOT seat traded at a positive spread to the CBOE seat, I simply financed the difference to not invade my trading capital. I always said I graduated from the Blue Jacket to the Striped Jacket. After that, I started to spend a lot more time at the CBOT. I traded a lot of corn and wheat. Soybeans, too, as I was involved with the “crush spread” quite a bit. Since the CBOT closed at 1:15 pm (Central time) every day, and the CBOE was open until 3pm, I still went down to the CBOE and traded some there, too. Ownership of a full CBOT seat (the yellow badge) gave one the right to trade on the CBOE as well – just as it always had, from the beginning of the CBOE. Ultimately, the CBOT introduced options on Treasury futures and then on Ag products which I traded as well.
 

Q : That’s all so interesting. What happened after that?

I stayed as a trader until the late 1980's, when I got involved with members of Congress, including Jesse Helms, the U. S. Senator from North Carolina to create an alternative price support system for U.S. agriculture. I created an initiative – an option strategy, which was really a put option – that allowed farmers to help manage their risk of holding a crop until it was sold. It allowed the U.S. government to privatize its grain storage since the put could be used in place of a loan by the farmer. The law passed as part of the Food Security Act of 1986. I sold my seat around 1990.

After spending time and effort to monetize the success of this initiative, I was approached by a firm in Washington (D.C.) to go to Russia and help develop new financial products there. Russia had just renounced communism and was privatizing a number of industries that required viable financial markets to grow their economy. Essentially, I helped develop the fixed income markets in Russia spending four years there, six years in Kazakhstan, and five years in Ukraine.

In 2009, I returned to the U.S. from Ukraine to join a firm called MarketGrader that had been established by good friends in Miami in 1999 where I have been ever since. We create indices and license them to ETF sponsors among other things. Our most well-known index is the Barron’s 400. We also analyze 40,000 listed companies globally and sell the research (ratings) and manage money through our RIA MarketGrader Capital, LLC.
 

David, thanks so much for agreeing to this interview. It is certainly enlightening to hear first-hand about floor trading in the early days of the CBOE. What a great career you have had.

Michael
Greenbaum

Founder, O'Connor & Associates

 

Forward by Lawrence G. McMillan:

Trader and mathematician Michael Greenbaum is famous in the world of option trading as the firm he founded – O'Connor & Associates – became synonymous with the highest level of derivative trading based on theoreticals and modeling. It eventually was a major player in nearly every form of derivatives arbitrage practiced on Wall Street.
 

The Untold Story of the CBOE's Good Fortune

by Michael Greenbaum

In late 1975 I was working on an encryption project for the Federal Government. I was in between some assignments and accompanied two friends to Chicago. My friends knew of my math background and urged me to visit their new jobs in Chicago. Both friends had always been in the securities industry and had ventured to Chicago for the new “game” called options. I had no securities industry background, but decided to see what this was all about.

My first day on the floor as a visitor was an epiphany. Whereas I saw that, for the most part, all of the market makers were trading on their gut instincts about the market's up and down gyrations, it was immediately obvious to me that the various call options were strictly mathematically related. I told my wife, in a phone call that first evening when I was in Chicago “I`ve died and gone to heaven”!

In that first week – while visiting – I took, and passed, the test required to become a market maker and spent long hours researching all of the then current materials about option pricing – including the Black Scholes model and a wonderful book co authored by Al Madansky and Gary Gastineau, The Stock Options Manual. It gave me important insights of how to more correctly price call options with a new model that I planned on developing.

It was my good fortune to have been introduced in that first week to Eddie O'Connor who, along with Joe Sullivan, was responsible for the creation of the CBOE. Eddie and his brother, Billy, owned the largest of the option clearing firms. He asked me how I intended on going about learning how to trade and I told him that I planned on doing so with my own model for calculating prices. He listened for quite a while about my thinking and then wished me good luck.

The next morning when back at home in New York, I received a phone call from Warren Shore who was the president of First Options Of Chicago. He told me that Eddie was very impressed with our meeting and wanted me to work for the firm`s management as a risk control officer. I was offered an excellent salary and jumped at the opportunity to set up computer programs to monitor market maker risk parameters. I also began giving classes several afternoons and evenings during the week to teach market makers about theoretical values for call options and how to do hedging of their positions.

In each of those first several years of the CBOE`s existence, the stock market never had any major advances; it tended to trade in narrow ranges or moved lower. The public, who were enamored with this new product – call options – were almost always buyers because the margin requirements were too high for them to be able to sell calls. The only public selling of calls was for positions referred to as “covered writes” which meant selling a call against a long stock position. While there were some such trades made by the public, the overwhelming majority of the volume in those early years was call buying by the public

Any of the then existing call pricing models always showed that calls were overpriced and therefore market makers were always on the sell side as they did not have the same onerous requirements as the public. Also, since I was in risk control and saw firm-wide exposure on a daily basis, I knew the risk to First Options if the market ever had a sudden positive surge. I also knew, that our competitor clearing firms – Shatkin, Brandt, Goldberg Bros. – were nowhere nearly as aware as we were of their exposure. The CBOE luckily escaped an early demise. There was not nearly enough capital in its infancy for the exchange to have survived a bull market.

The Birth of O'Connor & Associates (OCA)

By late 1976 First Options of Chicago was the largest of the clearing firms both in Chicago and with the expansions that had subsequently taken place from new exchanges – the Amex in New York, the Pacific in San Francisco and Philadelphia . Both Eddie and brother Billy O`Connor were well aware of the risk to their firm should a bull market arrive. First Options had a very sophisticated program that I had developed showing what would happen if there was a “3 sigma” move to the upside. While First Options would have been in reasonable shape because most of our market makers had been educated about the need to hedge, it was felt that the competitor firms were not and the entire exchange could fail!

In February of 1977, the two brothers asked me out to dinner and asked what I thought about starting up a propriety trading firm of my own with their financial backing. They also said, that if that was an idea that I liked, they would sell the clearing firm. They informed me that evening that they had been approached by the New York clearing firm, Speer, Leeds & Kellogg. It didn't take me long to reply to the brothers that I was excited to start up on my own. What would become O'Connor & Associates was fleshed out that very evening. They agreed to give me an initial capital of one million dollars and I would be the general partner with the limited partners being trusts for Eddie`s children.

Within days I commenced the transition by first hiring a new risk control officer to replace me at First Options and a business secretary charged with looking for my new office space. O'Connor & Associates was officially born on June 1, 1977 with offices on the 31st floor of the Board of Trade building.

Starting with my operations in 1977 we had a field day with the markets. We were always positive gamma, always! Our first “home run” was only a month after our inception, in TDY (Teledyne). It was a firm run by Henry Singleton, an MIT graduate. It was an early conglomerate and actively traded on the CBOE. The day of the July, 1977 expiration, also happened to be their earnings announcement before the market opening and we knew that it was their practice to announce then. The stock traded on that Thursday at $71/share and the market makers in the TDY crowd were only too happy to sell the July 70`s for a little over $1 since they were reasonably certain that the stock would be pinned, as was the usual case, the following day at $70. They based the option pricing on Black Scholes, for the most part, plus their thinking about the pinning. I was salivating all afternoon on that Thursday knowing, with the earnings coming pre market on Friday, that we could have a nice “jump.” We loaded up on Thursday by buying the July 70's and shorting the stock with positive curve. Luckily for us they announced very bad earnings, and the stock was halted for an hour or so on Friday morning and opened down $10 at 60. O'Connor & Associates had our first really major killing with a “back spread.” We made significant money – and all with almost zero downside risk.

Those market makers that continued to be big call sellers were required by their clearing firms to have larger capital positions. Their firms naturally grew smarter over time or simply failed. Those market makers that weren’t simply scalpers and elected to carry positions overnight of any size learned to be more conservative or they, too, failed. The bull market that commenced in August, 1982, forced all of the market makers to trade with the thought of being flat at night, and by then, sophisticated trading firms knew about better theoretical pricing models and the thinking behind gamma curvature.

I decided to retire in 1982, because I was burned out. I loved what I had created, of course, with the help of others, but I was a 100% workaholic and needed that to stop. I decided that O'Connor was in great hands with many hires that I had made that were even smarter than I.

Editor’s Note: Following a 1992 merger, O'Connor was combined with Swiss Bank Corporation's operations – a takeover. A number of O'Connor executives were brought into key positions within Swiss Bank. Elsewhere, other derivatives and arbitrage trading firms are still run by former O’Connor partners.

Mike
Gallagher

Co-founder, Lakeshore Securities

 

Interview by Lawrence G. McMillan, 2/12/2023

I met Mike Gallagher shortly after I joined Thomson McKinnon Auchincloss Kohlmeyer (TMAK) in 1976. Mike ran the Thomson operation on the floor of the CBOE at the time. Later, as I progressed to trading the TMAK arbitrage and option proprietary accounts, Mike and his partners were our main floor brokers on the CBOE. I talked to Mike recently, and asked him about some of the early days at the CBOE.
 

Q: Mike, how did you become the first Thomson employee to head up the floor operation on the CBOE?

I was a broker dealing in stocks on the American Exchange (AMEX), and in 1974 the AMEX decided that they wanted to list options, too. So there was an operation whereby they were simulating trading in options on the AMEX – training floor brokers, etc. That was in preparation for the AMEX Option Exchange, which eventually opened in 1975.

But in 1974, the firm I was working for went out of business. Howard Whitman was an executive at Thomson McKinnon, and he had previously been TMAK’s broker on the AMEX. Howard knew me and heard that my firm had gone out of business, so he contacted me about going to Chicago to be Thomson’s broker on the CBOE.

This was about the time that a number of the larger brokerage firms were setting up their own operations on the CBOE. Prior to that, the trades had been executed by “$2 brokers” who were CBOE members and who were independently self-employed.1 As the CBOE business grew, and the volume of option trading began to swell, the member firms (such as Merrill Lynch, Bache, Paine Webber, Thomson McKinnon, etc.) were paying these $2 brokers a lot of money. Their fee was oddly enough based on the price of the option traded. So, a very expensive option, which was trading at $10 or more per contract, earned the broker $3.00! In some cases, the payout was as much as $20,000 per month by a firm to an individual floor broker. So, the member firms decided it was more efficient to create their own floor operation.

Howard asked me to learn about options and to go to the CBOE to head up the original floor operation for Thomson. I said yes. That was December 1974. I spent about a month with the option department upstairs at TMAK and then moved to Chicago in January 1975. I hired a few people to help out (Bobby Fodor was my main assistant), and we began trading the retail order flow.

By that time, the CBOE had already expanded from their original operation in the old smoking room, to the new “Deck Floor.”2 That was where I set up operations. Originally, I just ran around the floor, executing retail orders.

There were some unusual things about that trading floor. For one, there was a smoking area that was roped off, right on the floor. For some crazy reason, I remember the girl that worked for us who was running the orders from the teletype machine – leaning over the machine and smoking a cigarette. On Fridays, after the close, we’d bring a case of beer into the booth while we reconciled the trades and closed out the week.

 

Q: Good stuff. Mike, as I recall, when I started running the proprietary trading desk at TMAK in 1981, you were already an independent broker by then. How did that occur?

I was happily employed at Thomson, but in 1979, they wanted me to move back to New York to become the National Sales Manager. I would have done it, but they didn’t want to give me a raise. There was no way that the same salary in Chicago went as far in New York; the cost of living between the two cities was significant. Besides, there was a lot of travel involved, and my wife and I had just adopted a new son. So, I gave my notice of resignation in late 1979 and left Thomson by January 1, 1980. After that, TMAK hired Tom Brady away from Merrill to run their floor operation. Tom eventually worked for the CBOE itself and is more well known as “Mr. Big.”

I tried some of the other firms: Salomon Brothers, Bear Stearns, etc. But they, too, wouldn’t pay more for a New York job than I was already making in Chicago.

So, I talked to my friend Van Hemphill, who was convinced there was a need for quality floor brokers who could consistently deliver good executions. We decided that we could start our own $2 brokerage operation, to offer service like that. We teamed up with Jeff Kaufman and Bobby Donnelly and formed DGHK– the initials of our last names, in alphabetical order. That was 1982. In the beginning, I was standing in the Superior Oil (symbol: SOC) pit most of the time. Superior Oil stock was trading at $300 per share, and so its options were very highpriced. Remember that $2 broker fee I talked about earlier? It was still in existence, so many of the SOC options were priced at more than $10 apiece, so one contract cost $1,000 or more. The $2 broker’s fee for trading that expensive option was still $3 per contract, so that was a nice piece of business, since there was heavy trading in SOC options. Van, Jeff and Bobby were all standing in the IBM pit, because there was so much business flowing into IBM in those days.
 

Q: You guys became the floor brokers with the most expertise in what the prop traders wanted to do – especially program traders. What led you into that?

Eventually, I also moved into the new Treasury Bond option pit that had opened. That was a lucky move, because in 1983, the CBOE began trading $OEX options in that same pit. $OEX was the first cash-based index option, and it exploded in popularity. It was an Index of 100 stocks with some of the largest market caps of the day.

We went to the first Risk Management Conference in 1984. That is a conference where some of the more sophisticated ideas regarding options are often presented. In talking with prop traders from Salomon Brothers and Oppenheimer, we realized that there was a ballooning market in “basket trading.” That is, traders would buy baskets of stocks and sell stock index futures against them (or the equivalent of stock index futures) to create an arbitrage. This was easy to do in the S&P 500 Index or the then-popular XMI Index, because there were futures trading on those indices.

But the $OEX was a cash based index, and there were no futures traded on it. It turned out that these prop traders were also using $OEX options to create baskets.3 But they were having trouble getting decent executions. They told us they “needed service,” so we began to quote “basket markets” for them.

There were plenty of opportunities for us with these “basket traders” or as they became to be known, “program traders.” The $OEX market makers hedged with the S&P futures at the CME (Chicago Mercantile Exchange). That meant we had the “100 vs 500 spread.”4 Then we had the New York firms doing baskets. The combo (long call, short put, for example) usually traded at a discount to cash. Then you had the early exercise that occasionally happened, leaving you unhedged. These positions would need to be rolled at expiration as well, so we quoted “roll markets,” which once again were very popular with the arbitrageurs. These were all markets that we had expertise in when most others did not.

Eventually, we noticed that some of these sophisticated prop trading desks were doing some very complicated orders – sometimes involving 6 or 8 legs in the same order. There was no one specializing in that type of execution. So, we did. Even today, in the world of electronic trading, many brokerage firms limit spread orders to 2 or 4 different option contracts in the spread.
 

Q: How did you get from there to the creation of Lakeshore Securities, which is still today one of the premier option execution brokers?

Bobby Donnelly left the firm, and we decided that we would create a new firm without using any of our names – that way, it could be longer-lasting. Van, Jeff, and I formed Lakeshore in 1985.

One of our best hires was Matt Filpovich (“Flip”) who runs the firm today. My son, Michael, works for Lakeshore, too.

The business has continued to thrive, even though Van, Jeff, and I have retired.
 

Mike: those were great insights into the origins of the TMAK operation on the CBOE, and into the beginning of index option trading. Thanks for sharing.

Van
Hemphill

Co-founder, Lakeshore Securities

 

Forward by Lawrence G. McMillan

Van Hemphill was one of the early floor brokers on the CBOE. He eventually partnered with others – some of whose interviews are on this website – to form one of the most formidable floor brokerage operations on the CBOE. I personally remember Van as the “face” of the short-lived NYFE options exchange, when he briefly came to New York; the NYFE ran full-page ads in the Wall Street Journal featuring Van as their “poster boy.” When I was running the prop trading desk for Thomson McKinnon in the 1980's we often used Van and his partners to execute “not held” orders – that is, we didn’t specify a limit, instead trusting the execution to the floor brokers who could see the order flow. Sometimes, that meant not getting an execution – which was fine – and it almost always meant we were getting the best execution possible.
 

I became a floor broker on the AMEX after graduating from college in 1968. When the CBOE opened in 1973, Bill Silver taught me the basics of options. Bill was a long-time trader on the AMEX, and he was fascinated with the new option markets. He used to sit with a Quotron and look at option prices all the time. He was involved early, trading options on the CBOE.

My firm sold my AMEX seat in July of 1974, so I asked Bill if he knew any firm that wanted a broker. He immediately made a phone call to Irwin Guttag, partner with Kaufmann Alsberg (KA). They were a huge arbitrage and warrants trading firm. Irwin asked me if I wanted to go to Chicago to work on the CBOE for KA. The timing was right for me, so I said yes. I moved to Chicago on September 15, 1974. I worked for KA for two years. I did a good job executing trades for them, and Irwin took good care of me.

But business was expanding all around me, so I bought my own seat in 1976, to become an independent floor broker. There were two kinds of memberships: 1) the market makers, trading for their own or firm accounts, and 2) floor brokers – filling orders independently or for member firms who employed them. I had left KA, but still had their order flow.

I positioned myself in the IBM pit, which was the busiest trading pit on the floor of the CBOE. When I had been on the AMEX, we had a hand signal system to enter orders and convey other information from the booth to the broker standing out on the floor, and vice versa. I used the same system on the CBOE floor in my new operation.

In the early days of the CBOE, there was always a delay in reporting stock trades from the NYSE. Kaufmann Alsberg had a broker in the IBM stock post on the NYSE, who would instantly relay last sale information. KA would put in orders to me in IBM options to take advantage of that information before the ticker tape caught up with the change in the stock price. There were two market makers who would always fill my orders – Bill Kornolak and Frank Gloskos. That’s because they wanted to see what I was doing for KA before other market makers knew. So, if I was a buyer, they’d sell to me and then turn around and buy other option series immediately.

This information was conveyed by phones. Yes, there were phones in the trading pits. The usage of the phone generally went to the guy who carried the biggest order flow. Thanks to the KA orders, that was me a lot of the time. I remember there was one time, I was in the Polaroid pit (which was a very active options pit in the 1970's). Bob Kantor was a market maker, and he got so angry about the order flow information I was receiving from New York, that he reached across me and cut my phone line with a pair of scissors!

I had known Mike Gallagher back on the Amex days prior to the CBOE. I really think that originally, both of us had thought that we’d go out to trade on this little exchange in Chicago until New York opened the “real thing.” But that wasn’t how it turned out, of course. The “real thing” was in Chicago, and New York never did catch on completely. The true believers in the CBOE were the people who made it work from the beginning – many of whom were independents and not the big money from New York.

Mike was running the CBOE floor operation for Thomson McKinnon (TMAK), but he decided to leave in January, 1980. He told me about this one night over drinks at The Sign of The Trader, the most popular bar for CBOE and CBOT traders. We decided to combine our talents and expand the independent floor brokerage operation. We were literally “two dollar brokers,” because that was the fee we got for executing an option contract (and it sometimes went up to $3 for options price over 10 dollars per contract).

In 1982, we also joined up with Jeff Kaufmann and Bob Donnelly, who were also independent floor brokers. Jeff had originally worked for Front Street and got to the CBOE in 1974. Bob came from the P-Coast [Editor’s note: the Pacific Coast stock exchange had begun trading listed options in 1976 and continued to do so until its trading floors were closed in the early 2000's].

We called the new firm DGHK (the initials of our last names, alphabetically). Mike, Jeff, Bob and I knew we weren’t risk-taking traders, but we knew how to get the best price in any market for our customers – many of whom were risk-taking traders.

Speaking of risk-taking traders, for some reason I am reminded of the story of a big trader in the Teledyne (TDY) pit. Norman was a big believer in trading by the stars. He watched them at night and would trade the next day based on what he saw. At one point, TDY was trading at 60, and the stars told him it was going down to 40. So, he sold naked calls and refused to cover: 65, 70, 72. Finally he was forced to cover because his clearing firm, Goldberg, threatened to buy him in. Shortly thereafter, the stock announced a 2-for-1stock split. The stars were right, but he was wrong.

In 1982, Irwin Guttag was involved with getting listed futures and options traded on the NYSE. The new exchange was called the NYFE (New York Futures Exchange). He asked me if I would come back to New York to help get the new exchange started. We (DGHK) thought this might be a good idea for our independent floor brokerage business as well, since we could expand operations to New York. I did help the NYFE, including being featured in full-page ads run in the Wall Street Journal.

Index Options were listed in 1983 (the CBOE 100 [OEX] was the first), and the NYFE started trading options and futures on the NYSE Index – a far less popular index than the Dow or the S&P 500. For a while there was considerable trading volume, and I was running a $2 floor brokerage operation trading those index futures and options. However, the exchange eventually faltered. I think the difference was that the NYFE was being backed by NYSE specialists who were trying to preserve their capital, whereas the CBOE was started because the Board of Trade (under the leadership of Eddie O’Connor) truly wanted to build a new exchange with risk capital.

By 1985, we at DGHK realized the NYFE just wasn’t working, and the operation in New York wasn’t producing enough to have me there. So, I went back to Chicago.

It was just after that when we were speaking to Sid Gold at Salomon Brothers (and others), and we realized that these sophisticated traders needed an equally sophisticated floor brokerage operation to handle their orders – despite the fact that their firm might have an operation of its own on the CBOE floor. These traders had their own models and were establishing 3- and 4-way spreads (and some with more legs than that).

At that time, we opened up a new booth on the CBOE floor. We called the new firm Lakeshore Securities. We joined the Options Clearing Corp so we could ‘give up’ Lakeshore Securities in the pit, thus disguising the true buyer.

There are a million stories I could tell, but I’ll end with this one. As the market was sinking on Friday, October 16th, 1987, some floor traders felt that the market was about to crash. They were right. Just before the close that night, one customer told me to “buy the book” in a deeply out-of-the-money OEX put option series that was offered at the minimum price of 1/16th ($6.25 per option). The ‘book’ was the exchange operated electronic system that held orders away from the current market. They had a 3 digit display, maximum 999. When I bought the book, I thought I was only buying 999 for the customer. When the trades cleared that night, though, it turned out he had bought 2,850 contracts. The next trading day (October 19th, 1987), the market crashed and those put options were worth thousands of dollars apiece.

Eventually, Mike, Jeff, and I all retired, but Lakeshore continues on to this day.

Shelley
Kaufman

Former Senior Options Analyst, PaineWebber

 

In February of 1974, I finished my four-year hitch in the Air Force and was able to parlay my degree in math into a position in the Arbitrage Department at PaineWebber, which was looking to add options trading to their risk arb and convertible bond efforts.

I was hired on a test basis, and started out doing small ratio hedges and butterfly spreads. Early on, there might have been 10-20 contracts in a given position. This was at a time when the pricing of options was not perfect, before the Black Scholes Model was ubiquitous and before every Chicago market maker had pricing parameters on their little handheld Hewlett-Packard calculators.

When pricing is imperfect, opportunities arise, as one can buy the underpriced options and sell the overpriced.

Careful trading, with the math in my favor, led to nice percentage profits on these small positions. This persuaded my supervisor to allow me to greatly increase the size of my positions. A butterfly, you might recall, is created as in this example, with all these options having the same expiration date:

Buy 1 call with a strike of 50 at $10
Sell 2 calls with a strike of 60 at $6
Buy 1 call with a strike of 70 at $3.

This is a completely hedged position, with a maximum risk of 1 point, which would occur at expiration if the stock closed at 50 or below or at 70 or above. The maximum profit would be 9 points at 60, and that profit would decrease point for point below or above 60, until reaching either of the two wings, at 50 or at 70.

These butterflies got bigger in position size with the aforementioned approval of the boss, and what used to be 5x10x5 quickly morphed into 50x100x50 or even bigger, until I was brushing up against the position limits imposed on this new type of security.

After a couple of months of making real money with large positions, I was called into the boss’s office early one morning and told that, because of my options trading, PaineWebber was now in violation of the SEC’s net capital requirements. Now, less than half a year out of the Armed Forces, I knew as much about firm net capital rules as I knew about the rules of cricket. That is, absolutely zippo.

Some fast research taught me that the SEC was not treating hedged positions in a manner that was a function of their risk, which is what net capital rules are actually supposed to do. Rather, the firm was taking a capital hit on the short calls, and a separate capital hit on the long calls, despite the fact that losses on one side would be offset by gains on the other.

The boss knew some people at the SEC and set up a meeting there for the very next day. We jumped on the shuttle at La Guardia and were in Washington speaking to some SEC bigwigs by early afternoon. To their credit, they quickly understood the (obvious) point I was making, and the rules were changed to more accurately account for the actual risk in hedged positions, as it affects net capital.

So, the happy ending was that we came into compliance with the rules, or, more accurately, the rules came into compliance with us, and I was able to continue my lengthy options trading career.

Congratulations to the CBOE on its Golden Anniversary, with gratitude for giving people like me a chance to operate in an exciting and often lucrative arena.

- Shelley Kaufman

Lawrence G.
McMillan

President, McMillan Analysis Corp.

 

I had been trading over-the-counter options for some time, ever since having read the book “Beat The Market,” by Edward Thorp (yes, the same guy who originally figured out how to properly count cards in blackjack and had also written “Beat The Dealer.”) Sometime in mid-1973, my broker Ron Dilks, called me and said that he had read an article in Business Week about listed stock options. It was about the Chicago Board Option Exchange (CBOE), which had begun trading listed options a few months earlier, in April of 1973. Later, it became an assumption that I was trading options on day one of listed options at the CBOE. I was, but not CBOE listed options. That began later in 1973. The standardization of options by the CBOE gave one the ability to easily construct option spreads and other more theoretical strategies.
 

There wasn’t much literature available on those subjects, though, but I got what I could. The first book I read was Stock Options (The Application of Decision Theory to Basic & Advanced Strategies), by James B. Cloonan, Ph.D. Cloonan claimed not to be beholden to brokers or trading firms. The book got into call ratio spreads (there were no listed puts at the time), and I found it very valuable. It is only 100 pages long. Cloonan eventually became President of the AAII (American Association of Individual Investors) and later hated options with a vengeance. I do not know why. This book got me thinking of all the ways that option combinations could be used, and it all seemed quite simple to me. I “got” options in a way that most people did not.
 

So, while I was learning about markets, I was delving deeper into option trading. I was working full-time at Bell Telephone Laboratories (Bell Labs) at the time. The whole “derivative” aspect was especially intriguing. I don’t remember exactly when or where I found out about the Black-Scholes model, but I think it was from guys at Bell Labs who were trying to trade options. Fisher Black and Myron Scholes were two professors who wrote an article called “The Pricing of Options and Corporate Liabilities” in 1970, and it was published in The Journal of Finance in May 1972. That was the Black-Scholes model, and it pre-dated the CBOE. Many people think the events happened the other way around, with the launching of the CBOE spurring the mathematicians to create a model, but it did not. I still have my original xeroxed copy of that paper, with all my notes on it as I tried to figure out the nuances of the model. I was able to code up the model on the computers at Bell Labs. I would go in every Saturday and type in all the option prices from the Wall Street Journal (there were only 16 stocks that had listed options originally, a number which expanded to 32 by the end of 1973 and to 40 by the time I wrote my first book). Each stock probably only had three expiration months and maybe five strikes that were pertinent, so it wasn’t too tall of a task to type them all in. Then I had the computers run analyses on the entire set of listed options – just as we still do today.
 

As an aside: in the beginning, I remember discussing the model with some guys at Bell Labs, and we figured with the model, it was going to be easy to make money. We would figure out the fair value of the option (there is a lot of language to that effect in the early papers on option pricing). Then, if the option was selling above fair value by a significant amount, we’d sell it, or if it was selling below fair value by a significant amount, we’d buy it. There is a major flaw in the strategy: in order to determine fair value, you’d have to know what realized volatility the underlying stock was going to trade at during the remaining life of the option. That is impossible to know! Hence there really is no such thing as fair value. You can say that an option is cheap or expensive with respect to historical volatility, but you have no way of knowing what volatility is going to be in the future. That doesn’t mean you can’t make a decent guess at what volatility is going to be, but then you are working with implied volatility and estimates of future implied volatility. It turns out that that is a much better approach. Anyway, back to the story.
 

As I was learning more about options, I was trading option positions with spreads, naked options, and other things with variable margin requirements. Commissions were still high at most places (the first discount commissions appeared in 1975). I coded that up in my Bell Labs computer program. In those days, the brokerage firms – even the margin departments – were not very computerized. Since I was still trading at Thomson McKinnon (which had acquired two more firms: Auchincloss and Company, and Kohlmeyer – a futures, cotton broker in New Orleans). So, the firm was now Thomson, McKinnon, Auchincloss, and Kohlmeyer – or TMAK for short. The head margin clerk at TMAK was Herbie Cohen, whom I got to know pretty well in those days. We would have daily arguments about what my margin requirements were, and I would always be right because my calculations were computerized. Eventually, it got to the point where Herbie would call me and ask me what my margin requirement was! I got to know Herbie very well when I finally went to work for TMAK – which happened in 1976, when I left my nice job at Bell Labs for the madness of Wall Street.

Shelly
Natenberg

Well-known author and trader, Option Volatility and Pricing

 

Interview by Lawrence G. McMillan, 5/1/2023

Shelly Natenberg is best-known as author of the book, Option Volatility and Pricing. He is respected as both a trader and an educator in the option business.
 

Q: As I’ve asked almost everyone being interviewed, how did you get into the option business in the first place? The answers are so varied since it was a brand-new industry 50 years ago.

As with many option traders in the early days, I got in the way most people got in – through a friend or relative who was already in the business. My brother had been a trader on the CBOE since 1974, and he suggested that I get into option trading. I wasn’t particularly enthusiastic, since I had no background in finance or economics. But I was good at math. So I started trading in December 1982. Shortly thereafter, I bought a Midwest Stock Exchange (MSE) seat, which gave me the right to trade a limited number of stock options. The MSE had listed options in Bristol-Myers (BMY), Superior Oil (SOC), Northwest Industries (NWI), Corning Glass (GLW), Diebold (DBD), and maybe a couple of others.

I was so raw that I didn’t even know how market-making worked. So, on my first day I didn’t know much. My brother didn’t want me to get killed, so he had a friend and trader in Bristol-Myers (BMY) and he asked him to watch over me. This friend turned to me and asked for a market in a specific option. I just looked up at the board and quoted the market from there. He said “I’ll buy on option from you.” Now what’s your market? Again, I quoted the listed market, and he took the opposite side, selling me one option on the bid. I made a sixteenth, $6.25, on the trade. Then he said, “OK, from here on you’re on your own.” At least I knew how it was supposed to work!

I traded on the MSE for about three months, and then I leased a full seat on the CBOE and traded IBM over there. It was in early 1982 that the CBOE took over the MSE Options Exchange and brought those options onto the CBOE. They offered the trading rights to those options.

Around 1984, the Chicago Board of Trade began trading listed options on T-Bonds. I figured this was a new market, maybe less sophisticated, and therefore maybe more opportunity. I leased a COM (Commodity Option Market) seat on the CBOT and traded there for about a year. Then the CBOT listed Agriculture options, and I bought a COM seat, which allowed me to trade all options on the CBOT. That become my “home,” and I traded grain options for 14 or 15 years. Grain options were very liquid. Corn and Soybeans had as many as ten market makers in each pit. There was lots of activity from Cargill and other grain houses, but also from farmers as well.

The grain options opened in 1986. I remember on the opening day, as you walked onto the floor, there was someone from the CBOT Research Department, handing out volatility charts of grain options. They wanted traders (especially traders not familiar so much with futures) to understand seasonal volatility. In IBM there’s not a big difference between volatility of July options and October options. But in the grains, there could be because the two were different underlyings. Winter volatility could be 15%, while summer volatility could be 40%, even though both were Corn options, for example.

Another thing that stock option guys weren’t used to was the way margin worked. You could be long futures and long puts, but if the market dropped you had to add margin to your losing futures position. The puts didn’t throw off any equity, even though they were increasing in value. This was an example of variation margin, which could be important since futures required such a small margin requirement initially.

I remember a couple of stories. One was that my brother and his friends, when they had a bad day, they’d go to White Castle to punish themselves. That was the worst food in the Loop.

Sometimes I’d watch my brother’s positions at the CBOE, even though I was at the Board of Trade. I’d come over for the close of trading, just to make sure nothing crazy was going on. I did that on the day before the Crash of ‘87 (Friday, Oct 16th, 1987). My brother’s positions were okay, but I remember watching a guy in OEX “buy the book” – buying a lot of put options for 1/16th ($6.25 each), in some out-of-the-money option right as trading was ending. He made a fortune, I’m sure.

One other observation: they always say that futures traders are the best traders, while option traders are the smartest traders. I’m not so sure about that, but there were two big differences that I saw between the CBOT and CBOE: 1) the CBOT was more physical, whereas the CBOE was a little more civilized (Ed: I don’t know about that! From some of the other stories we’ve heard) and 2) the CBOE was much more welcoming to women. Maybe 10% to 15% of the traders at the CBOE were women, whereas they were virtually none at the BOT in the futures pit, and only a few trading options.

One other remembrance I have is that of the new CBOE trading floor and building opening in 1986. There was a really gala affair introducing that.
 

Q: That sounds like some pretty fancy footwork, moving from one exchange to the other. How did the book come about?

Concerning my career as an educator, I had some friends who were futures traders who wanted to know something about options. So, I did a few informal classes for them. As a result of this, the CME asked me to teach more formal classes. I put the class notes together in a workbook, and someone suggested to me that I had the basis for a book. So, I approached a publisher in Chicago, and we reached an agreement. I was very, very surprised that people actually bought the book because it was targeted primarily at professional traders, a rather small group.

I wrote the first edition of the book in 1988, and it was strictly about futures options. The first revision was in 1994, and in that edition, I gave equal time to stock and futures options.

The book gave me credibility as a teacher and instructor. I went to work for Chicago Trading Corp (CTC) in the year 2000 to run their education program – teaching the traders they were backing. So, that’s when I left the BOT. I eventually retired from CTC in 2015.

One of the trading principles that I taught was “Don’t be afraid to admit you made a mistake.” Learn from it, and don’t repeat. It. If you don’t you could put yourself or your firm out of business. In this case, the firm was CTC.

A good example was something that had happened to me when I learned a strong lesson about early exercise and a few other things, too. It was April, 1986, and I had a long position in Corn puts as expiration neared. I exercised the puts that morning, since Corn was at 240 and the puts had a striking price of 300. I went to lunch. Most of the time, I never left the pit during the trading day, but that day I did. While I was out, Chernobyl happened. Grains exploded worldwide as it was uncertain what was going to happen to the supply of grain from Russia. When I got back, the market were going crazy and Corn was above 300, maybe 310 or 320. There was a rumor that a radioactive cloud was moving across Europe and that the grain crop over there could be wiped out. I had to cover at a loss. But there were several mistakes that I had made, and I never made them again.
 

Q: All floor traders have some interesting stories. Do you have others you’d care to relate?

There are myriad stories about big trading losses at the exchanges. Sometimes, the clearing corp that stood behind the traders was helpful in providing means for the traders to recover, and then sometimes the opposite occurred.

My brother was trading Kennecott Copper options on the CBOE in 1981. It closed on a Friday around $30. He was short some call options, and so were many of the other market makers in the pit. Over the weekend, Standard Oil of Ohio made a bid of $62 for Kennecott. My brother was clearing through Goldberg, and the Goldberg brothers – Dave and Bob – both told my brother that they would help him get back on his feet.

Sometimes it worked the other way, though. After the Crash of ‘87, many traders were wiped out, and the clearing firms were on the hook for the losses. At Goldberg, one trader had lost millions and he wanted to declare bankruptcy – meaning he would never pay Goldberg back, even if subsequently made a lot of money. There was a lawsuit, and I was an expert witness for Goldberg. Dave and Bob Goldberg won the case, although I don’t know if they were ever able to collect anything, but at least they had the opportunity to do so.

The ultimate story like that, though, was two T-Bond traders who illegally traded with each other, clearing through Lee Stern. One trader made a fortune and the other one lost. They tried to make off with the winning side and walk away from the losing side. It became a nationally publicized case, and Stern eventually won, with both traders going to jail.

In any case, it was a wild and wonderful time, and I’m retired now – still living in Illinois.
 

Thanks, Shelly, for some great memories of an option trader.

Paul
Stevens

Former CEO, Options Clearing Corporation

 

Interview by Lawrence G. McMillan, 5/5/2023

I have known Paul Stevens since the 1970’s. He has had a long a successful career in the options arena. Paul (an English major in college) was kind enough to write up some memories, and then we talked for a while, adding in more of his experiences.
 

Comments on the 50th CBOE anniversary

By Paul Stevens

I began my career as a Put and Call Dealer in 1968 with Saul Lerner & Co. It was a very small business, with eight or ten dealers in lower Manhattan. It was a “workout market” where not every bid got filled. A quote was just an indication and relationships with the member firm options desk was critical to getting your share of orders. In 1971, I joined Ragnar Options, a start-up with all of us still in our twenties. Our innovation was making firm quotes in addition to the workout quote. On a good day, we might have done 300 contracts. Our profit was the spread between what the buyer paid and what we paid the seller. It generally was $25 minimum per contract. We also bought straddles for inventory and offered “specials” in the WSJ once a week. Within six months, we were the largest put and call dealer by volume.

One of my vivid memories was a visit from Joe Sullivan, probably in 1972, who was making the rounds picking brains on behalf of the Chicago Board of Trade to determine the feasibility of listed standardized options. At one point, he was blocking our view of the blackboard, where all the bids were displayed. We politely asked him to move so we could continue working the orders. We did not give much credence to the notion that continuous firm markets could be sustained on an exchange. How wrong we were!

As the CBOE took shape and got ready to open, we bought a seat as a hedge against their success. I subsequently recruited my good friend Gary Lahey to go to Chicago as our market maker. As far as I know, we were the only put and call dealer to participate. We installed a hot line to the CBOE floor so Gary could call in his trades. They were quite small by today’s standard, generally 2’s and 3’s and 5’s, but never more than ten contracts. Gary went on to a long career as an independent market maker, serving as board vice-chair in the 80s.

As the American Stock Exchange was preparing to be the second listed options market in late 1974, they belatedly realized that they ought to have someone on staff that knew what an option was! Someone gave them my name, and I agreed to an interview and was hired on Dec.31, 1974, and began on Jan.13, a week before trading commenced. I enjoyed my 15-year tenure, working with the CBOE to fight the anti-options bias at the SEC, as well as by news media.

There were eventually four guys in the option department: Bill Brodsky, Ken Leibler, Howard Baker, and me. Kenny’s father was a principal in one of the old Put and Call Dealers: Marsh, Block, and Leibler. I had hired Kenny when we needed more help with marketing. Eventually, he became the head guy for Admin and Finance, and then was finally the President of the AMEX. Much later, I hired Joe Steffanelli, who had been an options guy at Bache, for options marketing.

I recall that one of my early tasks was to get a major rule changed. SEC Rule 19-B-3 was the format for proposing rule changes. Among other things, specialists weren’t subject to the margin requirements of RegT and could be financed in good faith by their clearing firm. The CBOE market makers were also exempt from Reg T, but the Registered Options Traders (ROTs), who performed the same function on the Amex were not exempt. This hampered liquidity, since the ROTs couldn’t easily hedge themselves without tying up a lot of capital. So, I wrote new regs, and we got the rules changed.

It’s crazy in hindsight, but the initial SEC approval was for calls only. We worked hard to get the SEC to understand that having puts available made not only economic sense but would serve to moderate risk. We had to revise disclosure documents and change a number of regulations to allow puts to be traded. And by the way, the SEC mandated that there would be no dual trading. Under their protective umbrella, the five exchange competitors would stage a lottery where we would choose, in order, up to the number of classes we were permitted. These sessions would extend into the wee hours, as member committees at each exchange took forever to debate what the next selection would be.

Another crazy limitation was the exclusion, at the outset, of Nasdaq stocks from being chosen. It wasn’t until 1985, twelve years after the CBOE opened, that Nasdaq stocks were permitted. By then, dual trading was allowed and the marketing effort to get the member firms’ designation was tremendous. The Amex with its specialist system won the day (in the dual listing war) and led to the adoption of a designated primary market maker system (a DPM is similar to a specialist) to replace the board broker system at the CBOE. As a CBOE official once noted, it was a wake-up call that didn’t cost them existing order flow and allowed them to assume a strong competitive posture that exists to this day.

After Bill Brodsky moved on to the Chicago Mercantile Exchange (CME) in 1982, I became an Executive Vice President, assuming major responsibilities including market operations, systems development, trading analysis as well as the Options Department. In 1989, the Options Clearing Corp (OCC) had a vacancy for the Presidency. At the time, I was a Board Member of the OCC, representing the AMEX. I was approached by head hunters asking for names to fill the vacancy, when they asked: “Paul, what about you?” I wasn’t so sure, but Wayne Luthringhausen (the Chairman of the OCC) brought my wife Peggy and me out to Chicago for a talk. Wayne’s wife, Karen, was especially helpful in showing Peggy around, and we were wined and dined. Eventually, Wayne made an offer, and I accepted it. That was October 1989.

After I left, Howard Baker was head of options at the AMEX. Howard was known for the creation of the Option Colloquium – a high-level annual gathering of academics and traders in New York. I was still in New York when he came up with the idea, and I was the one who suggested calling it a “colloquium.”

I always thought that I would get back to trading or sales, but administration grabbed me and never let me go. I kept getting promoted and things worked out well. I’m retired now, but still sit on the Board of the BOX Exchange (an electronic options exchange).

Paul, thanks for an insightful look into the early days of option trading, as well as your continued success in the field.

Howard
Baker

Head of AMEX Options, Organizer of the Options Colloquium

 

Interview by Lawrence G. McMillan, 5/8/2023

I have known Howard Baker since he organized the first AMEX Options Colloquium in 1981. Howard was instrumental in helping the launch of various options exchanges in Europe and would organize a Colloquium to coincide with those openings. Previously the head of the Options Division at the AMEX, Howard has been gracious enough to write some of his thoughts, which have then been expanded via a later interview.
 

I had no background in options whatsoever prior to joining the AMEX. It was just coincidental that my first day at the AMEX was Monday, April 23, 1973, three days before CBOE started trading. I was the Senior Compliance Attorney and later was appointed the Exchange’s Arbitration Director before being asked to become Special Counsel to the newly formed Options Division once AMEX got SEC approval in early 1975 to enter the options business. The four originals in the Division were Bill Brodsky, Paul Stevens, Ken Leibler and me.

This is an interesting story: Prior to joining the AMEX, I was Assistant Director of the Legal and Compliance Department at Halle & Stieglitz, an old-line retail brokerage firm which happened to own an inactive membership on the CBOT. Sometime in mid-1972, Halle's Managing Partner (Kjell Petersen) and Finance Head (Bill Wolfson) asked me to attend a meeting with them to meet a couple of guys from Chicago who were coming to NY to talk to CBOT members about a new Exchange that was going to trade stock options. Their agenda was to try to get the firm to activate its right as a CBOT member to a membership on CBOE. I believe the cost would have been $10,000.

The two Chicago folks turned out to be Jim Brucki and Bill Young. In any event, neither Kjell, Bill (Wolfson) or I had any knowledge about options and we barely understood what Jim and Bill (Young) were describing about contracts with standardized terms that would provide for a secondary market, etc, etc. Well, the meeting probably lasted an hour, and once the fellows left, Kjell and Bill looked at each other and decided this was not only a crazy idea but since the firm was not making use of its CBOT membership in any event that perhaps the best thing to do was to just sell the seat, which they did shortly thereafter.

As I said earlier, I started at the AMEX just before the CBOE opened and moved to the Options Division when it was created in 1975. While we all had diverse functions, only Paul (Stevens) had an options background and understood options trading. For the AMEX, one critical matter that needed to be solved before trading could commence was whether New York State would apply an interpretation to its tax law which might subject options transactions to a sales tax. The imposition of a tax on options trading would certainly have put the Exchange at a competitive disadvantage to CBOE. Bill (Brodsky) undertook the task to make sure that was not the case. And thank goodness he was successful! Kenny (Leibler) was hired to be our marketing person and came straight into the Options Division and was the principal draftsman of several of our earliest options brochures. He later left the Division and took on other roles at the Exchange – eventually becoming AMEX President.

One of my biggest contributions to options in general was the creation of the AMEX Options Colloquium. Sometime in late 1980, two Israeli fellows – Dan Galai and Menachem Brenner – came in to pitch the idea of a high-level academic-oriented options gathering to us. They had both received their doctorates in the U.S. and were very interested in options and were on their way back to Israel. Dan had received his degree at the University of Chicago about the time the Black-Scholes model was published which preceded the start of the CBOE. His professor pushed him to meet (CBOE President) Joe Sullivan, which he did, and Joe gave Dan access to CBOE’s floor trading records for the first six months of trading. With this information, Dan was able to develop some sophisticated research on options pricing and statistics.

Dan and Menachem said they and other academics had a lot of interesting studies on options trading, and asked whether the AMEX would be willing to give them a room where they could invite other academics to have a seminar. By this time, Bill had been promoted to EVP and left the Options Division and Paul was now in charge. He called me in to hear their pitch, and we learned that they had gone first to the CBOE but were turned down. I can’t remember why we did it, but we said we’d give them the use of our Boardroom to hold a one day academic seminar.

Somehow or other, word got around to the options trading desks and we started getting calls from those guys asking if they could come to this seminar as well. One thing quickly led to another and we knew we needed a larger location. So, we settled on the New York Downtown Athletic Club (home of the Heisman Trophy presentations) which was close to the Exchange. Paul came up with the name “Colloquium.” I’m not sure I even knew that word before he brought it up. And so, the first AMEX Options Colloquium was held on Monday, March 31, 1981 at the historic DAC.

We decided to make it a two-day event. Academics would speak the first day, and industry traders would speak the next day. We planned a series of panels with academics presenting papers on their research and traders talking about trading methods and strategies. On the day of the first Colloquium in 1981 (it was a Monday), things were going well until about noon when it was announced that President Reagan had been shot. Immediately, all the traders took off and returned to their offices while the academics sat around, a bit puzzled, not knowing exactly what to do.

Despite its infamous start, the Colloquium was hailed a success and lasted for another 16 years. After that first year, we mixed academics and practitioners, alternating panels throughout the two day event. Over the years, we had a varied list of presenters, including tax people, government regulators and, of course, academics and options traders. Our panel discussions covered a large number of topics – many of them addressing timely topics, including dual listings, multiple trading, triple witching, market structure, new products and LEAPS. The domestic colloquia proved so popular that we started holding them overseas. The first AMEX International Colloquium was in Switzerland in 1987 and we had seven more, many of them coinciding with the opening of listed options trading in Germany, Norway, Denmark, Italy and Belgium.

About LEAPS, they are nothing more than long-term standardized options. The idea for them came about after the Crash of ‘87, when so many people – both retail and professional – lost big money. While the stock market recovered many retail firms heightened their standards for the type of trading that retail customers could do. So, there was a thought among some options people that perhaps having longer term options contracts could draw retail customers back into the options markets. Through the AMEX’s working relationship with the Amsterdam-based EOE (European Options Exchange), we had heard about the success they had with long-term options. So, Andy Schwarz and I went over there and came back enthused. We got our Options Committee interested and later worked with the OCC and the other exchanges. Everyone liked the idea except the NYSE, which certainly wasn’t excited that longer dated options might be used more aggressively as a stock substitute. It was CBOE who came up with the term LEAPS (Long-Term Equity Anticipation Securities). Can you see why the NYSE didn’t like the CBOE calling these long-term options LEAPS – which sounded more like a stock product than an option? LEAPS were first listed by the CBOE in 1990.
 

Thank you, Howard, for an insightful look at both the beginning of option trading and at the creation of the Options Colloquium. I love that Halle and Stieglitz story!

Emily
Schmitz

Executive Assistant to Joe Sullivan, Chicago Board Options Exchange

 

Interview by Lawrence G. McMillan, 5/9/2023

Emily Schmitz was hired in early 1975 as an Executive Assistant in CBOE’s executive offices. With a career spanning over three decades and working in various areas with different assignments or responsibilities, Emily was privileged to observe and understand the different workings of the organization. When I was conducting some of the interviews for this project, I was told that I “had to talk to Emily.” So I did, and the following is what she had to say.
 

Q: Emily, can you tell us how you got to the CBOE?

A Board of Trade friend recommended I check out the CBOE which was hiring. CBOE was interviewing for an Executive Assistant in the Executive offices. After an interview and some tests, I left and went to lunch with my BOT friends not thinking much about the interview. I was offered the job at home that evening by phone and immediately accepted. The job turned out to primarily back up Joe’s assistant and to assist the EVP. There was one assistant for the entire area, and activity was constant and frenzied. Bruce Simpson (the EVP) came from Washington where he had a senior position with the NASD overseeing certain regulatory activities of brokerage houses. Bruce was older than most of the staff—in his forties—but then, the Personnel Office (as it was known then) indicated the average staffer was only about 27 years of age.

My first office space was in a hallway where my desk and a few others were sandwiched together wherever there was an inch to spare and not entirely by hierarchy. The space greatly improved once we moved to “executive” space on the BOT’s 22nd floor. The previous occupants—Lehman Brothers, I think—had left beautifully appointed offices at the northern end of the floor. Joe Sullivan took the walnut paneled office on one corner and Bruce Simpson (EVP) took the other pecan paneled office at the opposite corner. Joe’s office windows overlooked LaSalle Street. Other departments such as Legal, Research, and trading Support were assigned the inside space or small but functional offices along the outside frame of the floor. Unique space for the Membership offices was immediately off the reception area-- thoughtfully positioned far away from the Executive Area.

Joe Sullivan (we referred to him as JoeS) was only in his thirties and another VIP—Joseph Doherty (whom we called JoeD) was only in his 20s. They reflected the young staff which made up the employee roster. Every day crackled with excitement and staff made up for the lack of business sense with enthusiasm, energy and eagerness. In later years, we joked in reunions or get-togethers, about how those early years were like a bunch of kindergarten kids running amok. Realizing now the amount of activity that was needed to survive and keep up, youth was an asset and a blessing.

In the Joe Sullivan years, the foot traffic between the trading floor, executive offices, regulatory spaces and legal areas was constant. People felt they couldn’t get through on the phone to the senior executives, so why not just go to the offices and barge in or wait in the outer area, pacing and jockeying for attention? Traders generally came up after the close and committees met in the late afternoon and into the evening. Member firm VIPs and attorneys from Schiff Hardin were frequently present. Milton Cohen, who was looked upon with reverence, Burt Rissman, and their junior attorney, Mike Meyer, were respectful of everyone no matter their title, and were welcome what with their refreshingly calm presences. They generally met in Joe’s office, having come over from their Sears Tower offices.

Supporting the committees in the early, as well as later years, often meant late hours and smoke-filled meetings as smoking bans came much later. The traders and people were interesting, and I somehow found a way to master acronyms and associations. It was not apparent to me at the time that this was a skill which would pay off in later years in future CBOE roles.
 

Q: I know you feel very strongly about Joe Sullivan. Can you fill us in on some of that?

Joe had a Tennessee accent and would speak with a pause here and there (thinking ahead of speaking). Occasionally he left off a few words at the end of a sentence and the listener had to figure it out as Joe was already on to his next thoughts. Joe was an extraordinary wordsmith, especially in writing. His office was the center for many heated, smokey debates. Much of the time Joe had a cigarette in hand, held sort of at an angle if he was on the phone, but not always smoked through. Each morning his desk was outfitted with the required packs of Lucky Strike on one side (for morning) and Pall Malls on the other side (for afternoon). Joe walked into the office and out of the offices in a trot—slanting forward—often with his white shirt tail hanging out from under his jacket. We’d stop him and tell him “Tuck your shirt in,” and he would give a sheepish nod and comply.

There was no doubt to any of us staffers as to who lead the organization—it was Joe. He was admired for all that he was—a principled man of intelligence, fine character and integrity, something even the novices grasped. On the day Joe left the offices for the last time, he paused before me and gave his familiar nod of the head. Then he was gone. It was a very sad time for us who worked close to him, and we didn’t go into Joe’s vacant office for some time as it seemed like a sacred space.

During those early years, CBOE employees were plucked off right and left by member firms needing personnel with options backgrounds. The demand for CBOE personnel in the business community continued for decades. There were many instances where CBOE employees left, went to the member firm community only to return to CBOE. The Exchange went through many “RIFs”, or Reductions in Force, but many of them were lucky to be considered essential, thereby missing the pink slips.

Later when Bill Brodsky came to CBOE as the most senior officer it was as if a light had entered a tunnel. It was apparent from the beginning we had an experienced leader very different from predecessors. At some point, word came around that Bill was talking about a celebration for the Exchange’s 25th anniversary. This was an opening for good friends Jim Kipp, Corky Eisen and even Eddy O’Connor (who had given me his private number) to bring Bill up to date on some political maneuvers during Joe’s time. I think Jim met or spoke with Bill Brodsky first, and Corky and Eddy followed. What came out of those collaborations was a fantastic 25th anniversary celebration, which is now part of the historical context of CBOE. Bill put together a team--of which I was part. Joe Sullivan, Leon Pomerance, CBOE founders and dignitaries were present for many special activities as well as a beautiful dinner at Chicago’s Field Museum. One of my roles was to assist Leon Pomerance, a senior statesman and gentleman beyond compare, but who was in failing health, for the various celebrations. All of us were amazed but not surprised at the excellence of the occasions which Bill Brodsky had envisioned and accomplished.
 

Q: Wow, that is some story. Thanks for filling us in on that. Anything else that stands out for you?

Around early 2000—I can’t remember the exact dates—I got a call from Donald MacKenzie from the University of Edinburgh. He had been given my contact information by someone at the Board of Trade. Donald described a study he hoped would lead to a better understanding of the sociological and financial background which went into developing CBOE. Upon acquiring executive level permission, we set about finding a variety of people who agreed to an interview. Joe Sullivan was even a contributor of information. My connections helped but there was resistance and a bit of suspicion to overcome. Traders are reluctant to give out information that will be documented. But this turned out to be a very rewarding project and I was grateful for the opportunity.

Post the Joe Sullivan days, I assumed a variety of positions in various areas but found little competition in the fact of having daily worked and spoken with Joe Sullivan, and the other pioneers. This has made for great memories.
 

Thank you so much, Emily, for your unique slant on the history of the CBOE.

Thomas
Peterffy

Founder, Timber Hill & Interactive Brokers

 

Thomas Peterffy is well-know for founding the computerized trading firm Timber Hill and also for founding Interactive Brokers. Thomas recently was the Keynote Speaker at the May 2023 SIFMA meeting to commemorate the 50th anniversary of listed option trading. SIFMA is the Securities Industry and Financial Markets Association; it was formed from the merger of the Bond Market Association and the Securities Industry Association, in 2006. This is a copy of the speech that Thomas gave, about 50 years of listed option trading, through his personal experiences.
 

By the time I became a market-maker Member of the American Stock Exchange in 1977, option trading on the CBOE had been already underway for 4 years.

During the previous ten years, working as a computer programmer, I saved up $200,000 and wrote code on my Olivetti home computer to calculate the fair value of options.

Having all I needed to begin my career in options, I quit my job, bought a seat on the AMEX, opened an account at Spear Leeds and I deposited my remaining $165,000.

_______

On a bright October day, I walked down to the trading floor and began my 46 years as an options trader / securities broker dealer.

If you have difficulty understanding me today, just imagine my problems 46 years ago. Whenever I wanted in on a good trade, they claimed that they could not understand me. I was an out of place, odd duck on the floor, constantly looking at my fair value sheets.

There must have been nearly a thousand people, traders, brokers, clerks and exchange employees milling around on the floor. Every now and then, in the loudspeaker, they announced somebody’s name and called them senator.

They must have done something really good, I thought, maybe one day I’ll be a senator too.

And indeed, there came a day when the loudspeaker said, “Thomas Peterffy senator”. I excitedly turned to the trader standing next to me; “they just called me a senator, is there anything I am supposed to do now? In the loudspeaker, they just called me a senator” …. You dumb Hungarian, it’s not senator, he says send-to-door, as in send your clerk to the door, you have a delivery.

_______

Trading was really slow those days. If I did a hundred contracts by noon that was a busy day.

The AMEX had a specialist system. The specialist executed orders the brokers left on his book, he provided liquidity, trading for his own account. And he was also supposed to keep track of who was bidding and offering at what price for each option, in what time order among the few traders in the so-called crowd. At least that was what the rules provided for.

But of course, that was humanly impossible. And there were often arguments about who said what and when, but the word of the specialist was the law.

So, after watching this for a few weeks I went to the exchange officials and explained to them how much easier and more efficient it would be if everyone’s bids and offers were entered and maintained in a computer. The computer would have the rules and would decide on who gets to trade how many contracts, when and at what price.

_______

The exchange was run by the most powerful specialist firms who were completely opposed to this idea. Why? Because they made much of their profits from what they called their Time and Place Advantage. They knew what orders were on the book and could react faster to any news or price movement and lean on the market makers.

As an example: Broker comes to the post and wants to buy 50 of a specific call option. The specialist says: OK Sam you bought 50 at 4 and 3/8. How are the kids? What did you do this weekend? You should take your wife to see this fantastic play I saw, and he would proceed to tell everybody about the play. All the while he is watching the tape. If prices are firming and selling the calls is not such a good trade, he finally says to the broker: On the 50 contracts, I sold you 10 and these two gentlemen, pointing at us market makers, will sell you 20 contracts each. On the other hand, if he sees the market heading down, he would say, I sold you 40 and these two clowns will sell you 5 each.

_______

Trading days were generally slow except for a few flare-ups. That was when you had to make all your money. On a Thursday morning I am standing in Dupont the day before expiration Friday. Broker walks in, has 300 of a slightly out of the money, expiring calls to sell. My fair value is 27 cents, they are bidding 1/8, the broker says at 3/16. I buy all 300 at 3/16. Never done a trade that big, but at 18 dollars they were cheap and there isn’t much you can lose even if they go to zero. And indeed a few minutes later a broker runs in breathlessly bidding 3/8 for 500. Everybody is stunned. I am so carried away by the huge, $5600 dollar profit I just made on the 300 contracts in 3 minutes, that I sell him all the 500 he is bidding for. Literally a minute later the stock halts trading. News pending. Dupont announces a huge earnings beat and 3 for one stock split. I buy my 200 shorts back at 4 and ½, a loss of $82,000, nearly half my trading capital.

Relying on fair values, could not compete with trading on inside information.

_______

It took a long time to make that loss back and to build up capital. As I walked around the trading floor with my fair values, I saw a few prices out of line. But how to take advantage of them?

It took me a long time to come up with a plan. I needed a better computer that I could afford. Then IBM just came out with PCs.

_______

I rented an office and subscribed to the Quotron ticker from Reuters. The Quotron screen displayed the posted bids and offers on options, but I needed them in my PC. Reuters said they did not do that. We spliced into the Quotron wire and connected it to a port on the PC, through a chip that translated the pulses to characters. The PC could now store and update all the bids and offers on all the options.

I wrote a program that would look at each option and pick out the most over or under- valued ones relative to my fair values. It printed out the most advantageous spreads to buy or sell.

But if I started to walk around the floor trying to trade these spreads, the specialists would smell a rat. What to do?

I hired 4 attractive, young women, with Wall street experience, leased seats for them, taught them trading lingo and elementary understanding of options. They went down to the floor as market making members. They were instructed to call the office and we would tell them the best spreads to buy and sell. The specialists loved to trade and chat with the women. In 1982 we were making good money, for a while.

Even though we were buying offers and selling bids, after a while, the specialist began to realize that as much fun as it was to trade with the women it was not good business. They started to demand that our floor members make a market when called upon. They were right and I had a problem to solve. Making a market profitably was a very special skill which my traders did not have. What to do? This was when I came up with the idea of a handheld computer that would display option values and accept touch screen input so that it was small enough to hold in the trading crowd.

_______

I hired an electrical engineer hobbyist. While he was building the computer, I wrote the code in a stack language that our simple chip would understand. When our most persuasive trader showed up on the floor with our first handheld computer, she created quite a stir. Some options opened for trading later than usual, on that day.

Initially there was some debate among the specialists about whether or not to tolerate the machine in the crowd or reject it. They decided there was no way that a computer could outtrade them and they accepted it.

3 days later, the lithium battery exploded and blew off the back of the computer. The specialists gave us a pass.

The CBOE traders were not so sure that they could outtrade a computer and they would not let us use it on the floor. We appealed and appealed to higher and higher forums. I wanted to go to the SEC and plead in the name of more efficient markets, but I first had to exhaust all of my remedies at all lower levels. This took a very long time.

_______

In the meantime, it became clear to me: the more accurate we were, estimating or mathematically guessing the correct option values, the tighter bids and offers we could make, and the more value we would be adding to the marketplace. In order to improve further, we had to instantaneously hedge our positions and get the computers to communicate with each other.

That would be tough to get past the specialists. I had to find an exchange that was in urgent need of a liquidity provider and that was the New York Futures Exchange, a sub of the NYSE that listed options on what they called the New York Stock Exchange Index. The NYFE index consisted of all the NYSE listed stocks, cap weighted.

I promised to make a continuous, two-sided market if they allowed me to put computer screens on the floor that would display our bids and offers and accept touch input.

One Monday morning when the traders arrived on the NYSE floor they saw a stack of computer screens next to the trading pit. They insisted that they be moved to the wall. The wall was far enough, so that my traders could not see the numbers from the pit. New problem! In need of a quick solution. Instead of digits, we put colored squares on the screen. They can be seen from a distance. This worked.

_______

We asked the Amex to let us use the same setup and since the NYSE accepted, they could not very well refuse. They traded options on a stock index called XMI, consisting of 20 high cap stocks.

We built a network of PCs in the office and each PC was driving a computer placed on an exchange floor, and each of those drove a group of screens, strategically placed on the trading floor, flashing different colored squares.

Next, we added the PHLX, and the SOFEX since each of them had their own Index.

All these different stock indexes moved in the same way with the broad market. When one of our traders entered a trade at one exchange, it would come to our office, where the main computer would calculate the correlated impact of that new position on everybody else’s positions and adjust their prices so that the next trade would be more likely to be a risk reducing than a risk increasing trade. This was a very profitable business.

The CBOE then had the busiest index, the OEX, but still did not want to allow us to put our screens on the floor and when we put them in booths, they passed a rule that the screens must face away from the trading crowd.

The CBOE also had options listed on the S&P500 index, but for some reason nobody was interested in trading them. They were about to delist the product. I went to the Chairman and pledged to make a continuous, 100-up market in each option even if nobody came to trade for six months, IF he allows me to hoist 2 large computer screens in the middle of the pit.

He agreed. We began with great expectations. People came and stared at our screens, but nobody did a trade for weeks. Then suddenly, somebody started buying and over a few days accumulated over 10,000 contracts. But every time he bought a few hundred, he disappeared for 20 minutes. It hit me that he must be hedging his purchases. How can that be? We were hedging our sales instantaneously by raising our bids at all the other exchanges for similar products. There must be something wrong!

I went to the code and found the problem: Missing interest accrual. When our prices came up the next morning the fellow had a $2 million profit, and we had the opposite loss. But by that time all that trading drew other people into the crowd and the product was off to a sustainable start. Giving away money by mistake or intentionally may be the best way of marketing a product. Just ask a poker player.

Today the S&P 500 option is the most often traded and most popular financial product in the world.

_______

In 1990 the first electronic option Exchange opened in Germany. I went to Germany and made the usual deal. I’ll bring you liquidity and the technology to produce it, if you give me the ability to install it and use it.

We expanded our system to trade individual stocks and managed the positions using correlations.

Electronic exchanges suddenly opened in all the great cities of Europe and Asia, and we connected to all of them. By this time, we were easily making a couple of million dollars a day, but I spent most of that money on a large short position that kept going against us. Throughout my career I have been terrified of losing the company in a financial collapse.

In the US the exchange floors started giving us trouble. People cut our wires. We kept telling them if they do not go digital, they will lose out to foreign newcomers.

By this time radio communication among computers was done on local area networks. We put computers with radio transceivers on the exchange floors that were aerially connected with our smaller handheld units carried by our traders.

Looking at our vast, world-wide, network electronically connecting all the stock and option and futures exchanges, it occurred to us that that we could build graphical interfaces for other traders to talk to us from remote places. They would become our customers. Especially since I expected that eventually the US exchanges would go electronic, and all the floor-traders would need some electronic means of continuing their business.

We envisioned two traders in the busiest futures pit, the S&P500 futures. One would have all the customers’ buy orders along with our buy orders and the other all the sell orders. This would be displayed on radio connected touch screens held by them. All of our customers would see the same display on their screens. As they would place or modify their orders with their keyboards, the traders in the pit would see them, execute the orders, and enter the executions on their touch screens. This way Our customers would INTERACT with other traders and brokers on the US trading floors and electronic exchanges all over the world.

In 1993 we incorporated Interactive Brokers.

The floor traders we employed and their exchange memberships that allowed them to trade on the trading floors were expensive. I went to the SEC to ask if I could have my exchange market makers also represent customers’ orders. I promised that they would not know which orders were for the market maker and which for customers. They said no. I pleaded with them on efficiency, cost savings for customers, etc. I was denied.

We were slowly growing. In some futures pits and index options we could afford to keep traders AND brokers, but we had to increase order volumes for the brokerage to become profitable.

We started to add more capabilities and design more attractive GUIs to attract more professional traders.

Finally in 2000 the first US electronic options exchange, the ISE opened. We plugged in our machines as Timber Hill the market maker and as IBKR the broker. We had to make it demonstrably clear that there was no communication between them.

The market making business was doing really well but the broker needed help. As the other option exchanges in the US went electronic, many of their members became our customers. They were professionals and they had to make their living trading and we had to provide them with the means of doing so.

As a result, our brokerage platform became very professionally focused. We opened up our platform to anyone anywhere in the world who wanted to trade practically anywhere. Building a customer base became a real challenge.

_______

By 2007 we had equity capital of $4 billion, all of which, with the exception of the $200,000 I started with, were retained earnings.

We needed publicity and I was averse to advertising. I believed that if you build something really perfect, it will attract people by word of mouth. We did not start advertising until much later. We put the market-maker and the broker under Interactive Brokers Group LLC and we sold 10% of it to Interactive Brokers Group Inc.

In order to generate publicity, in May of 2007, true to our nature and convictions, we sold Interactive Brokers Inc in an electronic auction process to the public, without investment bank coverage, for $1.2 billion, listed under the symbol IBKR. In retrospect, saving the underwriting fee was a mistake. The big investment banks blackballed us, and we did not get all the publicity we needed and were hoping for.

After the 2009 crash, investors took a long time to recover. Our market making business started to lag our brokerage business. The problem was that new market- making firms emerged and they went to all the retail brokers and agreed to execute their orders and pay for them.

This practice was originally started by Madoff, he used the Cincinnati stock exchange, where he bought up most of the memberships, to take the other side of the orders he bought from retail brokers. He traded stocks and only CLAIMED to trade options for a fund where he produced very respectable, steady returns which turned out to be bogus.

At any rate, new market making firms started to buy up the retail flow in stocks and options and only the institutional flow came to the exchanges. The many small orders we used to trade with changed to fewer, larger orders that became difficult to trade with, profitably. We had to make a decision. Do we try to find a regulatorily permissible way to trade against our own brokerage orders and try to buy other flow? Or do we drop market making and just specialize in brokerage? We knew that our professional customers would protest against us trading with their orders. Some of them were already accusing us even though we have never done it. It would have been a clear conflict of interest even if it did not violate the rules.

About ten years ago, we sold the market maker on an earn out basis. It produced practically zero returns.

Since that time, we have been devoting all of our efforts to find ways to make our customers’ trading and investing more profitable for them.

We do that by providing economic and company-specific information and analysis. Educational resources. Screening tools to compare different securities and numerous different order types.

But MOST IMPORTANTLY, staying with our market maker expertise, we are constantly looking for ways to get better execution prices for our customers.

To this end we have provided our more professionally trained customers with order types that would enable them to interact with our less professional flow. Here we must be careful that all trades occur at prices better than available elsewhere.

Getting the best available prices is a problem not only for the retail but also for institutional investors. The more orders we get on both sides the closer we’ll come to crossing all the trades at the mid-price of the quote.

Our primary objective is to get more customers that generate more trading volume in order to achieve that.

In my view the next 50 years will be all about adding new products and making them cheaper and more attractive.

Today the public owns 25% of Interactive Brokers Group and the total market value of the firm is $32 billion.

This has been a fantastically rewarding 50 years for the options industry, for Interactive Brokers and our customers. And for this I need to thank all of YOU!!!

THANK YOU!!!!!

David
Krell

Chairman and co-founder of the International Securities Exchange (ISE)

 

Interview by Lawrence G. McMillan, 7/14/2023

David Krell was the Chairman and co-founder of the first U.S. electronic options exchange – the International Securities Exchange (ISE). I spoke with him recently, to get his perspective on what proved to be a very important development in option trading.
 

Q: David, can you fill us in on how you got to the point of starting an electronic options exchange?

I started with Hornblower & Weeks as a technical analyst, when listed options first started. Since they weren’t quite sure what to do with this new option product, Hornblower put the option department under the research department.

About two years later, I moved to White Weld, where I was the “options strategist.”

They were eventually acquired by Merrill Lynch in 1978.

In 1981, the CBOE wanted someone to be in New York to run a New York office. Jim Kelly, the floor broker for Goldman, who sat on various CBOE Committees, hired me. I reported to Dave Johnson until he left to run the CBOE floor operation for Morgan Stanley. I was then appointed to head the Marketing Division. At the time, Chuck Henry was the President of the CBOE. I headed a marketing team that was launched to promote, among other things, the “new” CBOE 100 Index (OEX). We also were interested in promoting Ginnie Mae options at the time, and also in getting brokers licensed properly to trade options.

Of course, the OEX was a huge product and a big success. Eventually, there was an agreement between the CBOE, the Chicago Merc (CME), and Standard & Poors Corporation, where S&P gave permission to trade options and futures on these floors exclusively. At that time, S&P took over the maintenance of the OEX.

After three years in that job, I moved to join the NYSE options operation, which was just getting started then. Ivers Riley – the Executive VP of the NYSE – was the head of that operation, and he called me to offer a job. Just some background on Ivers: he had been hired at the CBOE in the early days by Jim Dalton, head of marketing. When Joe Sullivan was forced out of the CBOE in 1979, the three of them – Joe Sullivan, Jim Dalton, and Ivers Riley – left to form The Options Group. Ivers was the Options Group partner who was hired by all the option exchanges to promote new products1.

Eventually, though, the NYSE decided to get out of the options business. That was 1997. It sold its business to the CBOE and moved its traders to Chicago (although not all wanted to move). That did not include the NYFE – the NY Futures Exchange – which was under the regulation of the CFTC and was a wholly owned subsidiary of the NYSE. It survived and eventually became part of larger futures exchanges – the New York Board of Trade, and then the International Commodities Exchange.
 

Q: So, that was all background to the creation of the ISE?

Yes, in 1997, people who wanted to create an electronic options exchange approached me and told me they were interested in backing me to run that operation. The original founders of the ISE were Bill Porter (then Chairman of E-Trade), Marty Averbuch, Gary Katz (who came over with me from the NYSE), and myself.

There had been some modest success with electronic exchanges in Europe, and we wanted to expand on that. We needed market makers, of course. Originally, we went to all the big firms who were not market makers on the then-current options exchanges: Morgan Stanley, Goldman Sachs, Bear Stearns, Deutsch Bank, etc. We told them their costs for trading would be cut by 50%. A big part of the effort was convincing them that the existing system was built to support floor members and traders, not the “upstairs” firms. For example, the option exchanges would charge firms 20 cents per trade, while floor traders paid 6 cents.

On May 26th, 2000, the ISE opened. Within two years, it had the largest market share of any exchange. There was huge opposition from the market-makers on the various floors.

[ Editor’s note: read the Bill Brodsky interview to see just how much internal strife there was at the CBOE over this issue.]

We were the first exchange to electronically display a firm quote. Eventually – and it took a while (longer than I thought) – we were able to display the size along with the quote.

Here are some added features of ISE:

a) there was Intra-market competition between primary market makers and competitive market makers
b) customers had priority at the best quote
c) the allocation of an incoming order was based on size for market makers (pro-rata rather than time) and customers traded first. This encouraged dealers to display the best prices as well as greater size. This was different from other electronic exchanges where all orders traded based on time.

Option volume expanded tremendously. We had traded 250 million contracts by early 2003. In 2005, we became the first exchange to go public: ISE became a public company in March 2005. That same year we traded our one billionth contract.

In December 2007, the German Exchange’s derivatives exchange Eurex bought ISE. ISE became a wholly owned subsidiary. Later, in 2016, they sold ISE to the NASDAQ.
 

Q: What foresight you had. The success speaks volumes about that. Are you still involved?

I left ISE when it was sold to NASDAQ. Gary stayed a little longer for a proper handover and retired afterwards.