Murphy A. (2009) The smartest boys in the alley, early derivatives on the London stock market

Murphy, Anne L. (2009) Trading options before Black-Scholes: a study of the market in late seventeenth-century London. Economic History Review, 62/1: 8-30.

The ledger of the financial broker Charles Blunt contains the details of some 1,500 transactions realized between 1692 and 1695, about a third of which regard the then novel trade in equity options (p.9). The technique had arisen in the 1620s in the commodity market and was proving very useful in the decade following the Glorious Revolution, when some 100 joint-stock companies were floated in London  (p.10). During the boom of the early 1690s, it is likely that “several thousand derivatives were transacted each year”.

Various strategies

Four out of five options traded were calls (i.e. the right to pursue a share at any time during a given period, usually 6 months) and at-the-money (i.e. for the price of the share at the time of the agreement). “It is likely that they were transacted to take advantage of an anticipated price move associated with a specific future event” (p.12). Most of Charles Bunt’s clients were not professionals, for them using a broker was the only way to find a buyer. However many of these amateurs did in fact engage in option trading.

“It is important to acknowledge the diversity of those who dealt in options. A market cannot exist unless it attracts participants with varying needs and attitudes towards risk, nor will it survive if it cannot accommodate those needs.”

The purchase of an option was often perceived as a sort of insurance as one ventured in a new company (p.14) or foresaw coming troubles. In this case the sellers’ premium really acted as an insurer’s fees. It was understood however that the safety offered was not complete and one could takes losses (p.16). Moreover, options offered a speculator’s the opportunity to take position without paying the full amount of the shares upfront, a welcomed characteristic in time of monetary instability. It was also a good way to preserve one’s profit.

Shared values

The shares emitted by the company were at times in such limited numbers that a single player could easily influence demand and share price using derivatives (p.17). Much worse: the existing statistical methods that could have been used to determine the options value were most certainly ignored by the practitioners (p.19). This shortcoming may have proved highly problematic, however Charles Blunt’s ledger indicates the actors seems to have intuitively agreed on a number of elements used in the valuation of the options (even if these elements actually elude us; p.21).

Even for volatile stocks, pricing response to increasing or decreasing uncertainty appears to have been consistent over time. “That is supportive of the assumption that option price was based on criteria that was agreed upon by all participants in the market” (p.22). Moreover the rule of put/call parity that avoids arbitrage trading appears to have been respected and implicitly understood. The price difference observed being easily explained in terms of interest charges and opportunity cost (p.24).

Conclusion

Overall pricing appears to have clearly advantaged the sellers, but these extra benefits can also be explained by the significant risks run by the sellers and by the use of options as insurance by the buyers rather than as a pure maximization instrument. Overall, the 17th-century London stock market appears to have been “orderly and effective” (p.26). Nonetheless, numerous opponents described it as a zero-sum game disturbing and at times taking down otherwise sound companies (p.27). Option trading was even several times outlawed (e.g. John Barnard’s Act of 1737).

But the practice proved resilient showing that it was certainly not significantly disruptive; moreover while public supervision seems to have been out of order, it is likely that the market’s own control mechanisms kept the system reasonably sound (p.28).

Disclaimer: this summary is written by the contributors of the blog and not by the author of the article. Any mistake is Manuel’s fault (and he shall be punished).

For once I’d also like to thank Oscar and Joost for the pointer.