[Federal Register Volume 60, Number 234 (Wednesday, December 6, 1995)]
[Notices]
[Pages 62517-62519]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-29685]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36526; File No. SR-PSE-95-28]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the Pacific Stock Exchange, Inc., Relating to Establishing a 
Hedge Exemption for Narrow-Based Index Options

November 29, 1995.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on November 
1, 1995, the Pacific Stock Exchange, Inc., (``PSE'' or ``Exchange'') 
filed with the Securities and Exchange Commission (``SEC'' or 
``Commission'') the proposed rule change as described in Items, I, II 
and III below, which Items have been prepared by the self-regulatory 
organization. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The PSE proposes to amend PSE Rule 7.6, ``Position Limits for Index 
Options,'' to establish a hedge exemption from industry (narrow-based) 
index option position limits which would allow PSE members and member 
organizations, as well as public customers, to exceed the established 
position limits for narrow-based index options by three times the 
established position limit for such index options, provided that the 
position is ``hedged'' with shares of at least 75% of the number of 
stocks comprising the index.\1\

    \1\Position limits impose a ceiling on the number of option 
contracts which an investor or group of investors acting in concert 
may hold or write in each class of options on the same side of the 
market (i.e., aggregating long calls and short puts or long puts and 
short calls). The PSE's proposal is identical to a proposal 
submitted by the Philadelphia Stock Exchange, Inc. (``PHLX''), See 
Securities Exchange Act Release No. 36380 (October 17, 1995), 60 FR 
54403 (October 23, 1995) (File No. SR-PHLX-95-45).
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    The text of the proposed rule change is available at the Office of 
the Secretary, PSE and at the Commission.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the self-regulatory organization 
included statements concerning the purpose of and basis for the 
proposed rule change and discussed any comments it received on the 
proposed rule change. The text of these statements may be examined at 
the places specified in Item IV below. The self-regulatory organization 
has prepared summaries, set forth in sections (A), (B), and (C) below, 
of the most significant aspect of such statements.

(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

Purpose
    The purpose of the proposed rule change is to establish a hedge 
exemption from the industry index option position limits established in 
PSE Rule 7.6(a).\2\ Specifically, the PSE proposes to add Commentary 
.03 to PSE Rule 7.6, which will provide that industry index option 
positions may be exempt from established position limits for each 
contract ``hedged'' by an equivalent dollar amount of the underlying 
component securities or securities convertible into such components, 
provided that each option position to be exempted is hedged by a 
position in at least 75% of the number of component securities 
underlying the index, and that the underlying value of the option 
position does not exceed the value of the underlying portfolio. The 
value of the portfolio is: (a) the total market value of the net stock 
position, 

[[Page 62518]]
less (b) the national value of (1) any offsetting calls and puts in the 
respective index option; and (2) any offsetting positions in related 
stock index futures.\3\ The values of any such index option position or 
related futures position are determined by aggregating the national 
value of each option contract comprising the position. Under the 
proposed exemption, position limits for any hedged industry index 
option may not exceed three times the limits established under PSE Rule 
7.6(a).

    \2\PSE Rule 7.6(a) provides the following position limits for 
industry index options: 5,500 contracts if, during the Exchange's 
semi-annual review, the Exchange determines that any single stock in 
the group accounted, on average, for 30% or more of the index value 
during the 30-day period immediately preceding the review; 7,500 
contracts if the Exchange determines that any single stock in the 
group accounted, on average, for 20% or more of the index value for 
that any five stocks in the group together accounted, on average, 
for more than 50% of the index value, but that no single stock in 
the group accounted, on average, for 30% or more of the index value, 
during the 30-day period immediately preceding the review; or 10,500 
contracts if the Exchange determines that the above conditions have 
not occurred.
    \3\National values are determined by adding the number of 
contracts and multiplying the total by the multiplier, expressing 
that number in dollar terms.
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    Members, member organizations, and public customers seeking to use 
the proposed exemption must obtain prior Exchange approval. In 
addition, the exemption requires that both the option and stock 
positions be initiated and liquidated in an orderly manner. 
Specifically, a reduction of the option position must occur at or 
before the corresponding reduction in the stock portfolio position.
    Under the proposal, exercise limits will continue to correspond to 
position limits, so that investors may exercise the number of contracts 
set forth as the position limit, as well as those contracts exempted by 
the proposal, during five consecutive business days.\4\

    \4\Exercise limits prohibit an investor or group of investors 
acting in concert from exercising more than a specified number of 
puts or calls in a particular class within five consecutive business 
days.
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    Currently, PSE Rule 7.6, Commentary .02, allows public customers to 
apply for position limit exemptions in broad-based index options that 
are hedged with exchange-approved qualified stock portfolios.\5\ Under 
the broad-based index option hedge exemption, a qualified portfolio is 
comprised of net long or short positions in common stocks or securities 
readily convertible into common stock in at least four industry groups 
and contains at least 20 stocks, none of which accounts for more than 
15% of the value of the portfolio. To remain qualified, a portfolio 
must meet the standards at all time, notwithstanding the trading 
activity in the stocks or their equivalents.

    \5\See Securities Exchange Act Release Nos. 32900 (September 14, 
1993), 58 FR 181 (September 21, 1993) (order approving hedge 
exemption for broad-based index options on a pilot basis); 35738 
(May 18, 1995), 60 FR 27573 (May 24, 1995) (order approving broad-
based index option hedge exemption on a permanent basis).
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    Although the broad-based index option hedge exemption applies only 
to public customers, the Exchange believes it is appropriate to expand 
the availability of the proposed narrow-based index option position 
limit exemption beyond public customers.\6\ The PSE believes that 
significant increases in the depth and liquidity of these index options 
could result from permitting firm and proprietary traders to be 
eligible for the exemption. According to the PSE, because customers 
rely, for the most part, on a limited number of proprietary traders to 
facilitate large-sized orders, not including such traders in the 
exemption effectively reduces the benefit of the exemption to 
customers. While large-sized positions in industry index options are 
most commonly initiated by institutional traders hedging stock 
portfolios on behalf of public customers, the PSE believes that 
proprietary traders should be afforded the same exemption so that they 
may fulfill their role as facilitators.

    \6\The Exchange proposes to apply only the proposed narrow-based 
industry index option hedge exemption, and not the existing broad-
based index option hedge exemption, to firms and proprietary traders 
as well as public customers. Telephone conversation between Michael 
Pierson, Senior Attorney, Market Regulation, PSE, and Yvonne 
Fraticelli, Attorney, Office of Market Supervision, Commission, on 
November 14, 1995.
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    The Exchange believes that its proposed narrow-based index option 
hedge exemption should not increase the potential for disruption or 
manipulation in the markets for the stocks underlying each index. The 
PSE notes that the position limits for narrow-based index options, even 
tripled, are far less than the position limits for most broad-based 
index options. In addition, the proposal incorporates several 
surveillance safeguards, which the Exchange will employ to monitor the 
use of this exemption. Specifically, the Exchange will require that 
member firms and their customers who seek exemptions file a form with 
the PSE, in lieu of granting an automatic exemption similar to that for 
equity options. The PSE's Options Surveillance Department will monitor 
trading activity in PSE-traded index options and the stocks underlying 
those indexes to detect potential frontrunning and manipulation abuses, 
as well as review to ensure that the closing of positions subject to an 
exemption is conducted in a fair and orderly manner.
    And lastly, the PSE notes that the provision itself contains 
several built-in safeguards. First, the hedge must consist of a 
position in at least 75% of the stocks underlying the index, so that 
the ``basket'' of stocks constituting the hedge will resemble the 
underlying index.\7\ Secondly, position limits may not exceed three 
times the limit established under PSE Rule 7.6(a). This places a 
ceiling on the maximum size of the option position. Third, both the 
options and stock positions must be initiated and liquidated in an 
orderly manner, such that a reduction of the options position must 
occur at or before the corresponding reduction in the stock portfolio 
position. Lastly, the value of the industry index option position may 
not exceed the dollar value of the underlying portfolio. The purpose of 
this requirement is to ensure that stock transactions are not used to 
manipulate the market in a manner benefitting the option position. In 
addition, these safeguards prevent the increased positions from being 
used in a leveraged manner.

    \7\To determine the share amount of each component required to 
hedge an index option position: index value  x  index multiplier  x  
component's weighing = dollar amount of component. That amount 
divided by price = number of shares of component. Conversely, to 
determine how many options can be purchased based on a certain 
portfolio, divide the dollar amount of the basket by the index value 
 x  the index multiplier.
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    For the above reasons, the Exchange believes that the proposed 
narrow-based index option hedge exemption should increase the depth and 
liquidity of narrow-based index option markets and allow more effective 
hedging with underlying stock portfolios, without increasing the 
potential for market manipulation or disruption, consistent with the 
purposes of position limits. For the same reasons, the Exchange 
believes that exercise limits should correspond to the position limit 
exempted granted by this proposal.
Statutory Basis
    The PSE believes that the proposal is consistent with Section 6(b) 
of the Act, in general, and with Section 6(b)(5), in particular, in 
that it is designed to remove impediments to and perfect the mechanism 
of a free and open market in a manner consistent with the protection of 
investors and the public interest.

(B) Self-Regulatory Organization's Statement on Burden on Competition

    The PSE does not believe that the proposed rule change will impose 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

(c) Self-Regulatory Organization's Statement on Comments on the 
Proposed Rule Change Received From Members, Participants or Others

    Written comments on the proposed rule change were neither solicited 
nor received.

[[Page 62519]]


III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reason for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (a) By order approve such proposed rule change, or
    (b) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    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 any 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 December 27, 
1995.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\8\

    \8\17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-29685 Filed 12-5-95; 8:45 am]
BILLING CODE 8010-01-M