[Federal Register Volume 59, Number 72 (Thursday, April 14, 1994)]
[Unknown Section]
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From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-7006]


[[Page Unknown]]

[Federal Register: April 14, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-33874; File No. SR-PSE-93-22]

 

Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Proposed Rule Change by the Pacific 
Stock Exchange, Inc., Relating to the Listing of Capped-Style Stock 
Index Options

April 7, 1994.

I. Introduction

    On August 20, 1993, the Pacific Stock Exchange, Inc. (``PSE'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of the 
Securities Exchange Act of 1934 (``Act''), 15 U.S.C. 78s(b)(1), and 
Rule 19b-4 thereunder,\1\ a proposed rule change to allow the Exchange 
to list capped-style stock index options (``capped options'').\2\ 
Initially, the Exchange proposes to list capped options on the Wilshire 
Small Cap Index and the PSE Technology Index (together, the 
``Indexes'').
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    \1\17 CFR 240.19b-4 (1992).
    \2\On October 20, 1993, the PSE amended its proposal to replace 
references to ``CAPS'' with references to ``capped-style'' options 
and to state that the Exchange plans initially to adopt a cap 
interval of 20 points. See Letter from Michael D. Pierson, Senior 
Attorney, Market Regulation, PSE, to Yvonne Fraticelli, Staff 
Attorney, Options Branch, Division of Market Regulation 
(``Division''), Commission, dated October 15, 1993 (``Amendment No. 
1''). On November 3, 1993, the PSE amended its proposal to indicate 
that the proposal will apply only to broad-based domestic index 
options and to clarify that Bridge Data Company calculates the 
opening and closing index values for the Wilshire Small Cap Index 
and the PSE Technology Index. See Letter from Michael D. Pierson, 
Senior Attorney, Market Regulation, PSE, to Yvonne Fraticelli, Staff 
Attorney, Options Branch, Division, Commission, dated October 29, 
1993 (``Amendment No. 2''). On February 7, 1994, the PSE amended its 
proposal to include new Rule 7.8(c), which will (1) indicate those 
indexes that have been approved by the PSE for capped option 
trading; (2) provide, in rule form, that, unless modified by the 
PSE, the cap interval will be $20.00; and (3) set forth the 
standards for listing and adding series of capped options. See 
letter from Michael D. Pierson, Senior Attorney, Market Regulation, 
PSE, to Michael A. Walinskas, Staff Attorney, Options Branch, 
Division of Market Regulation (``Division''), Commission, dated 
February 7, 1994 (``Amendment No. 3''). On April 5, 1994, the PSE 
amended the proposal to indicate that the PSE has developed 
procedures to identify and correct any exercise settlement values 
prior to clearance and settlement of such contracts at the Options 
Clearing Corporation. See letter from Michael D. Pierson, Senior 
Attorney, PSE, to Michael Walinskas, Branch Chief, Division of 
Market Regulation, SEC, dated April 5, 1994 (``Amendment No. 4).
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II. Description of the Proposal

    Proposed PSE Rule 7.1(r) defines a ``capped-style index option'' as 
an index option that is exercised automatically prior to expiration 
when the cap price is less than or equal to the closing index value for 
calls or when the cap price is greater than or equal to the closing 
index value for puts. The cap price, which is assigned by the Exchange 
when the capped option is listed, is the exercise price plus the cap 
interval for a call or the exercise price minus the cap interval for a 
put. Accordingly, the cap price is above the exercise price (i.e., 
strike price) for calls and below the exercise price (i.e., strike 
price) for puts. The difference between the strike price and the cap 
price is equal to the ``cap interval.'' Specifically, the PSE defines 
the cap interval as a ``value specified by the Exchange which, when 
added to the exercise price for the series (in the case of a series of 
calls) or subtracted from the exercise price for such series (in the 
case of a series of puts), results in the cap price for the series.'' 
The PSE has set as an initial standard, subject to Exchange 
modification that the cap interval for capped options must be 
$20.00.\3\
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    \3\See Amendment No. 3, supra note 1.
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    While capped options will be subject to automatic exercise due to 
movements in the underlying index, they also will be European-style, so 
that if the cap price is not reached prior to expiration the option can 
be exercised by the holder only at expiration pursuant to the rules of 
the Options Clearing Corporation (``OCC''). Thus, if the underlying 
index fails to reach the cap price during the life of the capped 
option, the option becomes European-style on the last business day 
before expiration.
    Upon automatic exercise of a capped option, the holder receives a 
cash settlement amount equal to the cap interval times the multiplier 
for the option. Under no circumstances, however, does the holder 
receive a cash settlement amount greater than the cap interval times 
the index multiplier. Therefore, the cap price establishes a maximum 
pre-defined value for the capped options. For example, if the index 
multiplier is 100, the index closes at 382 and the investor holds a 
capped call option with a strike price of 360 and a cap interval of 20, 
then the holder would receive a cash settlement amount equal to $2,000 
(20 times $100).
    Long capped call options closely resemble vertical bull spreads 
traded as a single security (i.e., the combination of one long and one 
short call position with the same expiration but where the strike price 
of the short call is higher than the strike price of the long call). 
Conversely, long capped put options closely resemble vertical bear 
spreads traded as a single security (i.e., the combination of one long 
put and one short put position with the same expiration, but where the 
strike price of the short put is lower than the strike price of the 
long put).
    The PSE has proposed the following rule changes to accommodate the 
trading of capped index options. First, the PSE plans to amend Exchange 
Rule 7.1, ``Definitions,'' to define ``capped-style option,'' ``capped-
style index option.'' ``cap interval,'' and ``cap price.''
    Second, the Exchange proposes to amend Exchange Rule 7.6, 
``Position Limits,'' to provide that capped options will be aggregated 
with standard index option contracts on the same stock index for 
position limit purposes. However, the Exchange proposes to amend 
Exchange Rule 7.7, ``Exercise Limits,'' to provide that capped options 
will not be aggregated with standard option contracts on the same stock 
index when calculating exercise limits. This amendment is designed to 
avoid instances where an investor would violate exercise limits by 
virtue of the automatic exercise of the capped options, an event over 
which the investor has no control.
    Third, the Exchange proposes to amend Rule 7.8, ``Terms of Options 
Contracts,'' to: (1) Indicate those indexes upon which capped options 
can be traded; (2) reflect that the cap interval for capped options, 
unless modified by the Exchange, shall be $20.00; (3) provide that 
initially, one at-the-money capped option call and put will be listed 
with an expiration of up to one year in the future and additional at-
the-money capped option series may be listed every two months with 
expirations up to one year in the future; and (4) capped option series 
may be added to expiration months with three or more months remaining 
to their expiration, if there has been a move of ten or more points in 
the index value.
    Fourth, the Exchange proposes to amend Exchange Rule 7.16, 
``Margin,'' to provide the following margin treatment for short 
positions in capped options. For cash accounts, the customer must 
deposit an amount equal to the cap interval times the index multiplier 
in cash or cash equivalents as defined in Section 220.8(a)(3) of 
Regulation T under the Act. For margin accounts, the margin requirement 
is 100% of the current market value of the contract plus 15% of the 
current index value times the index multiplier. In each case, the 
amount shall be decreased by any excess of the aggregate exercise price 
of the option over the current index value as multiplied by the index 
multiplier in the case of a call, or any excess of the current index 
value as multiplied by the index multiplier over the aggregate exercise 
price of the option in the case of a put; provided, however, that the 
minimum margin required on each contract shall not be less than (a) the 
option market value plus 10% of the current index value multiplied by 
the index multiplier or (b) the cap interval multiplied by the index 
multiplier, whichever is less. The maximum margin required on each 
contract shall not exceed the cap interval multiplied by the index 
multiplier.

III. Commission Findings

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities exchange, and, in 
particular, the requirements of section 6(b)(5),\4\ and, therefore, 
approves the Exchange's proposal.\5\ Specifically, the Commission 
believes that the capped options are an innovative financial product 
that will provide investors with additional choice and flexibility in 
their use of derivatives. In addition, capped options offer both 
holders and writers of options a means to participate in the options 
markets at a predetermined maximum gain or loss. Under the terms of the 
capped options, the option writer's (holder's) maximum loss (gain) is 
established at the time of the investment by the option's cap interval. 
Once the option's cap price (the strike price plus the cap interval for 
a call or the strike price minus the cap interval for a put) has been 
reached, the option is exercised automatically. The option writer's 
maximum potential liability is the amount of the cap interval, and, 
conversely, the option holder's maximum gain is the amount of the cap 
interval. Thus, capped options permit investors to participate in the 
options market at a known and limited cost. By limiting some of the 
risks associated with spread positions in American-style and European-
style options, capped options likely will make the options markets more 
attractive to a broad range of investors. In addition, the Commission 
notes that capped options, which are the equivalent of vertical bull 
and bear spreads traded as a single security, likely will benefit 
investors by providing them with a more efficient and cost-effective 
method of executing spread transactions.
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    \4\15 U.S.C. 78f(b)(5) (1984).
    \5\The PSE proposal is nearly identical to separate proposals to 
list and trade capped-style index options submitted by the CBOE and 
Amex and subsequently approved by the Commission. See Securities 
Exchange Act Release Nos. 29865, 56 FR 56255 (November 1, 1991) 
(order approving File No. SR-CBOE-91-24) and 29934, 56 FR 58593 
(November 20, 1991) (order approving File No. SR-Amex-91-24).
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    The Commission also finds that the specific rules proposed by the 
PSE to accommodate capped options are consistent with the Act.\6\ 
Specifically, the Commission believes it is reasonable for the Exchange 
to set a cap interval of $20.00 in that the cap price is placed 
sufficiently far from the exercise price so that the capped options 
will not be exercised automatically on a frequent basis.\7\
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    \6\The Commission notes that PSE Rule 7.1(q) defines capped-
style options and PSE 7.1(r) defines capped-style index options. 
Because the current Exchange proposal, as the Commission's approval 
order herein, is limited to capped options on the Wilshire Small Cap 
Index and the PSE Technology Index, should the PSE decide to list 
capped-style options on other indexes, including a foreign broad-
based stock index, a narrow-based stock index, or an individual 
security, then the Commission believes an Exchange rule filing made 
pursuant to Section 19(b) of the Act would be necessary.
    \7\The Commission notes that a rule filing pursuant to Section 
19(b) of the Act would be necessary if the PSE decided to change the 
present cap interval.
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    In addition, the Commission believes that the Exchange's proposal 
to bring up new at-the-money series of capped options every other month 
and after significant market moves is consistent with the Act because 
it will not result in a proliferation of options series. The Commission 
also finds that it is consistent with the Act to exclude capped options 
from exercise limit calculations because holders of capped options have 
no control over when their positions will be exercised, except on the 
last business day before expiration of the options. Moreover, the 
Commission notes that capped options are not excluded from position 
limit calculations, in that capped options are aggregated with non-
capped-style index options for position limit purposes.
    Finally, the Commission believes that the proposed margin treatment 
for capped options in cash and margin accounts is consistent with the 
Act. Specifically, the Commission believes that it is consistent with 
the Act to permit short capped options positions in a cash account so 
long as the maximum exposure (the difference between the exercise price 
and the cap price times the index multiplier) is deposited. This 
position is the equivalent of a completely covered position, because 
the maximum risk of loss is already on deposit. In addition, the 
Commission believes the proposed margin requirements for capped options 
positions maintained in margin accounts are consistent with the Act 
because they are virtually identical to the margin requirements for 
short stock index options positions in non-capped style stock index 
options held in margin accounts, except for the fact that a limit equal 
to the maximum exposure to the option writer is placed on the margin 
requirement. It is reasonable to limit the margin in this fashion 
because, if the limit is invoked, the margin covers 100% of the 
exposure to the writer and no additional margin calls need be made.
    Lastly, the Commission believes that the automatic exercise feature 
of capped options necessitates that, when the PSR lists capped options 
on a specific index, the PSE ensures that the exercise settlement value 
for the index is accurate at all times. An erroneous exercise 
settlement value could conceivably result in the unwarranted automatic 
exercise of capped options and the irreversible elimination of an 
options position. Accordingly, in this regard, the Commission notes 
that the PSE has developed procedures to identify and correct any 
exercise settlement values prior to settlement of such contracts at 
OCC.\8\
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    \8\See Amendment No. 4, supra note 1.
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    The Commission finds good cause for approving the PSE's proposal to 
list capped options prior to the thirtieth day after the date of 
publication of notice of filing thereof in the Federal Register because 
the Exchange's proposal is substantially the same as the formerly 
submitted and approved CBOE and Amex proposals to list and trade capped 
options.\9\ The Commission received no adverse comments on the CBOE or 
Amex proposals during the 21-day comment period. The Commission also 
does not find any different regulatory issues arising from the PSE's 
proposal. Thus, the Commission believes it is appropriate to approve 
the proposed rule change on an accelerated basis in order to facilitate 
competition between the exchanges for product services, which, in turn, 
should benefit public investors. The Commission believes, therefore, 
that good cause exists for approving the proposed rule change on an 
accelerated basis.
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    \9\See note 5, supra.
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IV. Solicitation of Comments

    With respect to the PSE proposal, including all amendments, 
interested persons are invited to submit written data, views and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying at the 
Commission's Public Reference Section, 450 Fifth Street, NW., 
Washington, DC. Copies of such filing will also be available for 
inspection and copying at the principal office of the above-mentioned 
self-regulatory organization. All submissions should refer to the file 
number in the caption above and should be submitted by May 5, 1994.
    It it therefore ordered, Pursuant to section 19(b)(2) of the 
Act,\10\ that the proposed rule change (SR-PSE-93-22) is approved.

    \10\15 U.S.C. 78s(b)(2) (1988).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\11\
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    \11\17 CFR 200.30-3(a)(12) (1993).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-7006 Filed 4-13-94; 8:45 am]
BILLING CODE 8010-01-M