Option Fundamentals   • 7
studies (i.e., his contractual rights had value through expiration—option 
characteristic number 4).
This is only one example of an ancient option transaction (a few thou-
sand years before the first primitive common stock came into existence),  
but as long as there has been insurance, option contracts have been a well-
understood and widely used financial instrument. Can you imagine how 
little cross-border trade would occur if sellers and buyers could not shift the 
risk of transporting goods to a third party such as an insurance company? 
How many ships would have set out for the Spice Islands during the Age of 
Exploration, for instance? Indeed, it is hard to imagine what trade would 
look like today if buyers and sellers did not have some way to mitigate the 
risks associated with uncertain investments.
For hundreds of years, options existed as private contracts specifying 
rights to an economic exposure of a certain quantity of a certain good over 
a given time period. Frequently, these contracts were sealed between the 
producers and sellers of a commodity product and wholesale buyers of 
that commodity. Both sides had an existing exposure to the commodity  
(the producer wanted to sell the commodity, and the wholesaler wanted to 
buy it), and both sides wanted to insure themselves against interim price 
movements in the underlying commodity.
But there was a problem with this system. Let’s say that you were a 
Renaissance merchant who wanted to insure your shipment of spice from 
India to Europe, and so you entered into an agreement with an insurer. The 
insurer asked you to pay a certain amount of premium up front in return 
for guaranteeing the value of your cargo. Y our shipment leaves Goa but is 
lost off Madagascar, and all your investment capital goes down with the 
ship to the bottom of the Indian Ocean. However, when you try to find 
your option counterparty—your insurer—it seems that he has absconded 
with your premium money and is living a life of pleasure and song in 
another country. In the parlance of modern financial markets, your option 
investment failed because of counterparty risk. 
Private contracts still exist today in commodity markets as well as 
the stock market (the listed look-alike option market—private contracts 
specifying the right to upside and downside exposure to single stocks, 
exchange-traded funds, and baskets is one example that institutional 
investors use heavily). However, private contracts still bring with them a