[Federal Register Volume 61, Number 39 (Tuesday, February 27, 1996)]
[Notices]
[Pages 7295-7297]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-4313]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36858; File No. SR-PHLX-95-45]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval of 
Amendment Nos. 1, 2, and 3 to the Proposed Rule Change by the 
Philadelphia Stock Exchange, Inc., Relating to the Industry Index 
Option Hedge Exemption

February 16, 1996.
    On September 18, 1995, the Philadelphia Stock Exchange, Inc. 
(``PHLX'' or ``Exchange'') submitted to the Securities and Exchange 
Commission (``SEC'' or ``Commission''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to amend PHLX Rule 1001A, 
``Position Limits,'' to establish a hedge exemption from industry 
(narrow-based) index option position and exercise limits.\3\

    \1\ 15 U.S.C. 78s(b)(1) (1988).
    \2\ 17 CFR 240.19b-4 (1995).
    \3\ 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). 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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    The proposed rule change was published for comment in the Federal 
Register on October 23, 1995.\4\ No comments were received on the 
proposed rule change. On December 20, 1995, on February 14, 1996, and 
on February 16, 1996, the PHLX amended its proposal.\5\

    \4\ See Securities Exchange Act Release No. 36380 (October 17, 
1995), 60 FR 54403.
    \5\ On December 20, 1995, the PHLX amended its proposal to 
specify certain requirements and monitoring procedures which the 
Exchange will use in connection with the hedge exemption. See Letter 
from Gerald D. O'Connell, First Vice President, Market Regulation 
and Trading Operations, PHLX, to Michael Walinskas, Branch Chief, 
Office of Market Supervision (``OMS''), Division of Market 
Regulation (``Division''), Commission, dated December 20, 1995 
(``Amendment No. 1''). Among other things, Amendment No. 1 indicates 
that the PHLX will monitor accounts utilizing the hedge exemption on 
a daily basis; that the hedging portfolio must be previously 
established and that options must be carried in an account with an 
Exchange member; that initiating or liquidating positions should not 
be conducted in a manner calculated to cause unreasonable price 
fluctuations or unwarranted price changes; and that the PHLX's 
Market Surveillance Department must be notified of any material 
change in the portfolio or futures positions which materially 
affects the unhedged value of the portfolio. Amendment No. 2 
modifies the proposal by providing that the industry index hedge 
exemption will be two times the existing position and exercise limit 
rather than three times the limit because the hedged option position 
is held in addition to the contracts currently permitted under the 
Exchange's rules. In addition, Amendment No. 2 indicates that 
offsetting positions in stock index futures options must be deducted 
from the total market value of the net stock position to determine 
the value of the hedging portfolio. See Letter from Gerald D. 
O'Connell, First Vice President, Market Regulation and Trading 
Operations, PHLX, to Michael Walinskas, Branch Chief, OMS, Division, 
Commission, dated February 14, 1996 (``Amendment No. 2''). On 
February 16, 1996, the PHLX amended its proposal by adding 
subparagraph (C) to paragraph (b)(2) of Commentary .01 in order to 
make clear that economically equivalent positions must be deducted 
from the market value of the net stock position to determine the 
value of the underlying portfolio. See Letter from Gerald D. 
O'Connell, First Vice President, Market Regulation and Trading 
Operations, PHLX, to Michael Walinskas, Branch Chief, OMS, Division, 
Commission, dated February 16, 1996 (``Amendment No. 3'').
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    The PHLX proposes to exempt from position and exercise limits any 
position in an industry index option that is hedged by share positions 
in at least 75% of the number of component stocks of that index or 
securities convertible into such stock.\6\ Under the proposal, no 
position in an industry index option may exceed two times the narrow-
based index option position specified in PHLX Rule 1001A(b)(i) \7\ and 
the value of the index option position may not exceed the value of the 
underlying hedging portfolio. The value of the underlying hedging 
portfolio is determined as follows: (1) the total market value of the 
net stock position, less (2) the value of: (a) the notional value \8\ 
of any offsetting calls and puts in the respective index option class; 
(b) the notional value of any offsetting positions in stock index 
futures or options; and (c) any economically equivalent positions.\9\

    \6\ The PHLX permits the use of convertible securities in its 
equity option hedge exemption. See Securities Exchange Act Release 
No. 32174 (April 20, 1993), 58 FR 25687 (April 27, 1993) (order 
approving File No. SR-PHLX-92-22). Similarly, other options exchange 
permit the use of convertible securities in broad-based index hedge 
exemptions. See Securities Exchange Act Release No. 35738 (May 18, 
1995), 60 FR 27573 (May 24, 1995) (File Nos. SR-Amex-95-13, SR-CBOE-
95-13, SR-NYSE-95-04, SR-PSE-95-05, and SR-PHLX-95-10) (permanently 
approving hedge exemption pilot programs).
    \7\ PHLX Rule 1001A(b)(i) provides the following position limits 
for industry index options: 6,000 contracts if any single stock 
accounted, on average, for 30% or more of the index value during the 
30-day period preceding the review; 9,000 contracts if any single 
stock accounted, on average, for 20% or more of the index value or 
any five stocks together accounted, on average, for more than 50% of 
the index value, but no single stock in the group accounted on 
average, for 30% or more of the index value during the 30-day period 
preceding the review; or 12,000 contracts if none of the above 
conditions apply. See Securities Exchange Act Release No. 36194 
(September 6, 1995), 60 FR 47637 (order approving File No. SR-PHLX-
95-16) (increasing position limits for industry index options to 
6,000, 9,000 or 12,000 contracts).
    \8\ Notional values are determined by adding the number of 
contracts and multiplying the total by the multiplier, expressing 
that number in dollar terms.
    \9\ See Amendment Nos. 2 and 3, supra note 5.
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    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.
    The proposed exemption requires that both the options and stock 
positions be initiated and liquidated in an orderly manner. 
Specifically, a reduction of the options position must occur at or 
before the corresponding reduction in the stock portfolio position.
    The proposed exemption will be available to firm and proprietary 
traders, as well as public customers. According to the PHLX, because 
customers rely, for the most part, on a limited number of proprietary 
traders to facilitate large-sized orders, failure to include such 
traders in the exemption could effectively reduce the benefit of the 
exemption to customers.
    The PHLX believes that the hedge exemption provision is necessary 
to better meet the needs of investors who would use PHLX industry index 
options for investment and hedging purposes. The PHLX states that many 
institutional traders and portfolio managers deal in dollar amounts 
much greater than permissible under current position limit levels and 
have expressed that Exchange position limits hamper their ability to 
fully utilize Exchange index options. As a result, the PHLX believes 
that many index options are ineffective for such traders, who may as a 
result choose to 

[[Page 7296]]
use futures instruments.\10\ Thus, the PHLX believes that the proposed 
hedge exemption should alleviate the situation where investors with 
substantial hedging needs are discouraged from participation in the 
options markets by existing position limits.

    \10\ Under rules promulgated by the Commodity Futures Trading 
Commission, futures positions that are deemed to be bona fide 
hedging transactions (as defined) are exempted from position limit 
rules. See Securities Exchange Act Release No. 25739 (May 24, 1988), 
53 FR 20204, (June 2, 1988) (order approving File No. SR-CBOE-87-
25).
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    The PHLX believes that the 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. In 
this regard, the proposal incorporates several surveillance safeguards, 
which the PHLX will employ to monitor the use of this exemption. 
Specifically, the Exchange will require that an application for 
exemption be filed by member firms and their customers who seek hedge 
exemptions. The Exchange will review the application and approve only 
those applications that satisfy the hedge exemption requirements. The 
Exchange's Market Surveillance Department will monitor trading activity 
in PHLX-traded index options and the stocks underlying those indexes to 
detect potential frontrunning and manipulation abuses, as well as 
review such trading to ensure that the closing of positions subject to 
an exemption is conducted in a fair and orderly manner.\11\

    \11\ See also Amendment No. 1, supra note 5.
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    The PHLX also 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. Thus, the ``basket'' of 
stocks constituting the hedge resembles the underlying index.\12\ 
Second, the proposal provides a ceiling on the maximum size of the 
option position by providing that positions established under the 
proposal may not exceed two times the limits established under PHLX 
Rule 1001A(b)(i). Third, both the options and stock positions must be 
initiated and liquidated in an orderly manner, meaning 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 cannot exceed the dollar value of the 
underlying hedging portfolio. The purpose of this requirement is to 
further ensure that stock transactions are not used to manipulate the 
market in a manner benefiting the option position. In addition, these 
safeguards prevent the increased positions from being used in a 
leveraged manner by ensuring that the options position subject to the 
increased position limit is properly ``covered'' by the hedge.

    \12\ 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  index multiplier.
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    For the above reasons, the PHLX believes that the proposed industry 
index hedge exemption should increase the depth and liquidity of the 
markets for narrow-based index options and allow more effective hedging 
with underlying stock portfolios without increasing the potential for 
market manipulation or disruption, consistent with the purposes of 
position and exercise limits.
    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) thereunder.\13\ The 
Commission concludes that providing for increased position and exercise 
limits for narrow-based index options in circumstances where those 
excess positions are fully hedged with offsetting stock positions will 
provide greater depth and liquidity to the market and will allow 
investors to hedge their stock portfolios more effectively, without 
significantly increasing concerns regarding intermarket manipulations 
or disruptions of either the options market or the underlying stock 
market.

    \13\ 15 U.S.C. 78f(b)(5) (1988 & Supp. V 1993).
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    Specifically, the PHLX proposal contains safeguards that should 
make it difficult to use the exempted positions to disrupt or 
manipulate the market. First, requests for the exemption must be 
approved by the PHLX, which should ensure that the hedges are 
appropriate for the position being taken and are in compliance with 
PHLX rules. Second, the stock portfolio must consist of at least 75% of 
the number of component securities underlying the index, and must 
correspond in value to the value of the options position hedged, so 
that the increased positions are less likely to be used in a leveraged 
manner in any manipulative scheme. As noted above the value of the 
hedging portfolio is equal to (1) The total market value of the net 
stock position; less (2) the value of (a) any offsetting calls and puts 
in the index option; (b) any offsetting positions in related stock 
index futures or options; and (c) any economically equivalent 
positions.\14\ Third, both the options and the stock positions must be 
initiated and liquidated in an orderly manner. Moreover, a reduction of 
the options position must occur at or before the corresponding 
reduction in the stock portfolio position, thereby helping to ensure 
that the stock transactions are not used to impact the market so as to 
benefit the options positions. Fourth, the PHLX's Market Surveillance 
Department must be notified in writing for approval prior to 
liquidating or initiating any such position and the PHLX's Market 
Surveillance Department must also be notified of any material change in 
the portfolio or futures positions which materially affects the value 
of the qualified portfolio. Fifth, the maximum hedge exemption position 
is two times the existing limit. The ``two times the limit'' is not 
automatic and the PHLX has the authority to approve a hedge limit for 
less than that amount.

    \14\ See Amendment Nos. 2 and 3, supra note 5. According to the 
PHLX, ``economically equivalent'' positions are instruments whose 
prices fluctuate in tandem. The PHLX believes, for example, that 
National Over-the-Counter Index options and Nasdaq 100 Index options 
are economic equivalents, and that stock and bonds issued by the 
same company may be economic equivalents. Telephone conversation 
between Edith Hallahan, Special Counsel, Regulatory Services, PHLX, 
and Yvonne Fraticelli, Attorney, OMS, on February 14, 1996.
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    The Commission notes that the PHLX's surveillance procedures are 
designed to detect as well as deter manipulation and market 
disruptions. In particular, the PHLX will monitor the options position 
of a person utilizing the hedge exemption on a daily basis to ensure 
that each option contract is hedged by the equivalent dollar amount of 
component securities.\15\ In addition, the PHLX's Market Surveillance 
Department will monitor trading activity in PHLX-traded index options 
and their underlying component stocks to detect potential frontrunning 
and manipulation, and to ensure that the closing of positions subject 
to the exemption is conducted in a fair and orderly manner. Violation 
of any of the provisions of the industry index hedge exemption, absent 
reasonable justification or excuse, will result in the withdrawal of 
the hedge exemption and 

[[Page 7297]]
subsequent denial of an application for a hedge exemption thereunder.

    \15\ Market participants granted a hedge exemption are also 
required to keep their application forms for the hedge exemption 
current and promptly provide the PHLX with any information 
concerning the dollar value and composition of the stock portfolio, 
the current hedged and aggregate option positions, and any stock 
index futures positions, or economically equivalent positions.
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    Finally, the Commission believes that it is reasonable for the PHLX 
to allow firm and proprietary traders, as well as public customers, to 
utilize the proposed hedge exemption. The Commission believes that 
extending the narrow-based index option hedge exemption to firm and 
proprietary traders may help to increase the depth and liquidity of the 
market for industry index options and may help to ensure that public 
customers receive the full benefit of the exemption. Moreover, the 
PHLX's monitoring procedures, as described above, should be able to 
detect abuses and ensure that the options position, whether firm, 
proprietary trader, or customer, is properly hedged.
    The Commission finds good cause for approving Amendment Nos. 1, 2, 
and 3 to the proposed rule change prior to the thirtieth day after the 
date of publication of the notice thereof in the Federal Register. 
Specifically, Amendment No. 1, is designed to protect investors and the 
public interest by providing additional requirements and surveillance 
procedures which the Exchange will use in monitoring the narrow-based 
index option hedge exemption. Amendment No. 2 clarifies the Exchange's 
proposal by indicating that the hedge exemption allows a market 
participant to hold up to two times, rather than three times, the 
current position limit because the hedged position is held in addition 
to the contracts permitted under PHLX Rule 1001A. In addition, 
Amendment No. 2 strengthens the PHLX's proposal by providing that 
options on stock index futures must be deducted when calculating the 
value of the hedging portfolio. Amendment No. 3 strengthens the PHLX's 
proposal by making technical revisions that clarify, among other 
things, that economically equivalent positions must be deducted when 
calculating the value of the hedging portfolio. Accordingly, the 
Commission believes that there is good cause, consistent with Sections 
6(b)(5) and 19(b)(2) of the Act, to approve Amendment Nos. 1, 2, and 3 
to the proposal on an accelerated basis.

Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment Nos. 1, 2, and 3. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, 
D.C. 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, 
N.W., Washington, D.C. 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 March 19, 1996.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\16\ that the proposed rule change (SR-PHLX-95-45), as amended, is 
approved.

    \16\ 15 U.S.C. 78s(b)(2) (1982).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\17\

    \17\ 17 CFR 200.30-3(a)(12) (1995).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-4313 Filed 2-26-96; 8:45 a.m.]
BILLING CODE 8010-01-M