“To the extent possible the pilot program should be designed to serve as a complete test of the feasibility of a full scale market and of the Board’s capacity to provide adequate regulation.”
In the 1960s, the grain futures business was flat, so the 120-year-old Chicago Board of Trade (CBOT) began looking for a new line of business. One opportunity appeared to be in the old “put and call” market. A few brokers had always been willing to write contracts to sell (put) or buy (call) equities at a specific time at a specific price, but most investors shied away, since there was no continuous market.
By 1969, the CBOT had decided to create a marketplace for what would henceforth be called “exchange traded options.” The SEC approved this “pilot program” in 1971 and two years later registered the CBOE as a national securities exchange, making it the first options exchange to become a self-regulatory organization under the public/private partnership model established in 1934.71
The architect of the exchange was Joseph Sullivan, a former journalist who had gone to work for the CBOT. He created the organization along mostly traditional lines. The CBOE was owned by its members, about 350 at first, although an agreement with the CBOT granted trading privileges to some 150 of its members. Like other self-regulatory organizations, the CBOE was committed to representative governance. Policy was set by a member-elected board of directors, and board committees oversaw administrative, disciplinary and government functions. A staff led by Sullivan monitored compliance, conducted examinations of member firms, and evaluated market maker performance.72
The trading floor, built in the former CBOT smoking lounge, was more innovative. There were no broker-dealers. “Board brokers” kept limit order books, while market makers maintained a fair and orderly market by trading for their own account. But in contrast to those at the NYSE, CBOE market makers did not specialize. Instead, they competed to trade a number of options, an arrangement intended to tighten spreads and increase liquidity. For the pilot program, the SEC limited the CBOE to offering sixteen standardized call option contracts. Purchasers got a right to buy equities in 100-share increments at a point in time three, six, or nine months distant at a fixed “striking price.”73
By the summer of 1973, the CBOE was doing six times the volume of the old put and call business, spurring others to get into options. In 1975, the AMEX and the Philadelphia Exchange both opened options floors; the Pacific and Midwest Stock Exchanges followed in 1976.74
Market innovation accompanied early growth. Veteran put and call traders relied mostly on intuition and experience. But just months after the opening of the CBOE, economists Fischer Black and Myron Scholes published “The Pricing of Options and Corporate Liabilities,” which provided a mathematical model for judging the performance of options. Soon the veterans gave way to younger traders wielding carefully-calibrated mathematical models. In 1975, “Black-Scholes” was officially adopted by the CBOE for computerized price reporting.75 That same year, the CBOE moved into new space with a 20,000-square-foot trading floor and turned its attention to the trading of put options, obtaining SEC permission to launch five of them in June 1977.76