Stock market option trading remains one of the most visible columns of the derivatives markets’ relentless march into the financial systems of the world. Derivatives may have started out as instruments for hedging of risk, then pure speculation, but they have long been used as a vehicle for corporations to use to manipulate the balance sheet, and so provide investors with the alleged financial picture that the board would like to present.

The three way dance

Whilst investment banks innovate, producing endlessly complex instruments of financial engineering, the corporations, municipalities, hedge funds, and individual investors pay handsomely for them, all the while satisfying Wall Street's endless striving for new ways to bamboozle investors (and satiate boardroom greed). And it has become an increasingly frenetic dance of investment bankers and company directors, with state regulators do little to nothing to prevent the rest of us being injured when the jig gets out of hand. Stock market option trading is a case in point.

Options themselves are relatively simple to describe - they offer the purchaser the option, but not the obligation, to buy (or sell) the stock that underlies the option; usually at a contracted price (strike) and expiry date. You pay up-front for the option and are essentially given a potentially unlimited participation in a stock’s rise (or fall). Originally considered as a cheaper and more flexible means of being able to construct hedges, options were quickly picked up by speculators as fantastic vehicles for making leveraged bets on the state of the stock market today.

Employee stock options – an incentive to greed

For corporations, stock market option trading offered them the opportunity to move boardroom incentive packages 'off the balance sheet’, as the costs of employee stock options being exercised are conditional. So initially the FASB (the U.S. accounting standards regulatory body), ruled that costs were left out of accounting expenses, and there was a massive boom of such issues to employees.

Such options were marketed as incentives to employees, but the bulk went to executives, where the main incentive was to manipulate the short term earning of companies to boost share prices, and maximize returns on stock options granted to them. And research has shown that these options increased the level of risk taking of firms. The best performing mutual funds were those that took the highest risk while providing incentives for their managers to do so in the form of stock options.

Once the FASB caught up, pressed by scandals over illicit stock market option trading, and ruled that employee stock options be counted as costs (albeit using options valuation models of the corporate choosing) the issuance of employee stock options plummeted. According to Reuters Fundamentals, the grants of stock options by S&P 500 plunged from 7.1 billion in 2001 to 4 billion in 2004. The investment banks and accountants have since been busy trying to find new ways to satisfy the swelling remuneration packages of the boardroom.

Investing in stocks is an entirely different ball game compared to stock market option trading, the latter being an enabler of leveraged positions, and remains a destabilizing influence in the global financial system – as Warren Buffett put it “In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."