Option Pricing Methods in the Late 19th Century Thursday, 29 September, 2016

We at Quantpedia consider ourselves a history freaks as we love books and papers related to a history of finance. The work of Dotsis is a perfect example of an interesting paper about a history of option pricing and shows how people were remarkably skilled in assessing price of options even without current high performance IT tools. Academic paper could be related to #20 - Volatiity Risk Premium Effect ...

Authors: Ghoddusi

Title: Option Pricing Methods in the Late 19th Century

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2831362

Abstract:

This paper examines option pricing methods used by investors in the late 19th century. Based on the book called “PUT-AND-CALL” written by Leonard R. Higgins in 1896 and published in 1906 it is shown that investors in that period used routinely the put-call parity for option conversion and static replication of option positions, and had developed no-arbitrage pricing formulas for determining the prices of at-the-money and slightly out-of-the-money and in-the-money short-term calls and puts. Option traders in the late 19th century understood that the expected return of the underlying does not affect the price of an option and viewed options mainly as instruments to trade volatility.

Notable quotations from the academic research paper:

"In this paper I show that option traders in the late 19th century not only had an intuitive grasp of the main determinants of option prices but they have also developed no-arbitrage pricing formulas for determining their prices. The option pricing formulas are described in a book called “PUT-AND-CALL” written by Leonard R. Higgins in 1896 and published in 1906.2 Higgins was an option trader in London and in his book he describes option pricing methods and option strategies used in the late 19th century in the City of London.

The pricing approach described in Higgins book could be summarized as follows: First, traders were pricing short-term ATMF straddles (30, 60 or 90 days to maturity. The prices of the ATMF straddles were set equal to the risk-adjusted expected absolute deviation (Higgins uses the term average fluctuation) of the underlying price from the strike price at expiration. The expectation of the absolute deviation was based on historical estimates plus a risk premium for future uncertainty as well as some other markups. Given the ATMF straddle prices as reference points Higgins is using a linear approximation formulae based on put-call parity to price slightly out-of-the-money (OTM) and slightly in-the-money (ITM) put and call options. I show that the approximation used by Higgins is analogous to a first order Taylor expansion around the ATMF straddle price.

Higgins’s book is an important reference in the history of option pricing because it provides a pricing framework based on empirical rules and approximation methods for determining option prices. Higgins’s method could be taught in introductory derivatives valuation courses before the Black and Scholes and the binomial model to help students appreciate the historical development of option pricing methods and the contribution of option market practitioners."


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