[Federal Register Volume 61, Number 62 (Friday, March 29, 1996)]
[Notices]
[Pages 14168-14172]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-7704]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37017; File No. SR-Amex-96-03]


Self-Regulatory Organizations; American Stock Exchange, Inc.; 
Order Approving Proposed Rule Change by the American Stock Exchange, 
Inc. Relating to the Listing and Trading of Options and Long-Term 
Options on the Networking Index and Long-Term Options on a Reduced-
Value Networking Index

March 22, 1996.

I. Introduction

    On January 23, 1996, the American Stock Exchange, Inc. (``Amex'' or 
``Exchange'') submitted to the Securities

[[Page 14169]]
and Exchange Commission (``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 provide for the listing and 
trading of index options on The Networking Index (``Index''). Notice of 
the proposed rule change appeared in the Federal Register on February 
13, 1996.\3\ No comment letters were received on the proposed rule 
change. This order approves the Exchange's proposal.

    \1\ 15 U.S.C. Sec. 78s(b)(1) (1988).
    \2\ 17 CFR 240.19b-4 (1994).
    \3\ See Securities Exchange Act Release No. 36812 (February 6, 
1996), 61 FR 5590.
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II. Description of Proposal

A. General

    The Amex proposes to trade options on The Networking Index, a 
modified equal-dollar weighted index developed by the Amex comprised of 
15 computer and telecommunication networking stocks which are traded on 
the Amex, the New York Stock Exchange, Inc. (``NYSE''), or through the 
facilities of the National Association of Securities Dealers Automated 
Quotation system and are reported national market system securities 
(``NASDAQ/NMS''). In addition, the Amex proposes to amend rule 901C, 
Commentary .01, to reflect that 90% of the Index's numerical value will 
be accounted for by stocks that meet the current criteria and 
guidelines set forth in Rule 915.

B. Eligibility Standards for Index Components

    The Networking Index currently conforms with Exchange Rule 901C, 
which specifies criteria for inclusion of stocks in an index on which 
standardized options will be traded. In addition, the Index also 
currently conforms to all the criteria set forth in Rule 901C, 
Commentary .02, which provides for the commencement of trading of 
options on an index thirty days after the date of filing, with the 
exception that the Index is calculated using a modified version of the 
equal-dollar weighting method. Therefore, the component securities all 
meet the following eligibility standards: (1) They are traded on the 
Amex or NYSE, or are NASDAQ/NMS securities; (2) component stocks 
comprising the top 90% of the Index by weight have a minimum market 
capitalization of $75 million, and those component stocks constituting 
the botton 10% of the Index by weight have a market capitalization of 
at least $50 million; and (3) stocks constituting the top 90% of the 
Index by weight have minimum monthly volume of 1,000,000 shares over 
the six months preceding this filing, and stocks constituting the 
bottom 10% of the Index by weight have a minimum monthly volume of at 
least 500,000 shares over the six months preceding this filing.

C. Index Calculation

    The Index is calculated using a ``modified equal-dollar weighting'' 
methodology. Four of the fifteen component securities are given higher 
weightings to reflect their higher market capitalizations relative to 
the rest of the group, while not allowing their weightings to dominate 
the Index to the extent they would in a straight market capitalization 
weighted Index. According to the Amex, this method of cacluation is 
important given the great disparity in market value of a few of the 
Index's components. It has been the Exchange's experience that options 
on market value weighted indexes dominated by relatively few component 
stocks are less useful to investors, since the index will tend to 
represent these few components and not the industry as a whole. At the 
same time, the increase in Index weight for the smaller, less liquid 
stocks is lower than if the index had been straight equal-dollar 
weighted; and the decrease in Index weight of the larger, more liquid 
stocks also is less dramatic than using straight equal-dollar 
weighting.
    The following is a description of how the modified equal-dollar 
weighting calculation method works. As of the market close on October 
20, 1995, a portfolio of networking stocks was established representing 
an investment of $12,000 in each of the four most highly capitalized 
securities in the Index and $4,727.27 in each of the 11 remaining 
stocks (rounded to the nearest whole share). The value of the Index 
equals the current market value (i.e., based on U.S. primary market 
prices) of the sum of the assigned number of shares of each of the 
stocks in the Index portfolio divided by the Index divisor. The Index 
divisor was initially determined to yield the benchmark value of 200.00 
at the close of trading on October 20, 1995. Each quarter thereafter, 
following the close of trading on the third Friday of January, April, 
July and October, the Index portfolio will be ranked in descending 
market capitalization order and the Index portfolio adjusted by 
changing the number of whole shares of each component stock so that the 
four largest capitalized stocks in the Index each represents 12% of the 
Index value for a total of 48%, and the remaining 52% of the Index 
value is evenly distributed over the remaining securities. At the 
inception of the Index, each of the remaining 11 components had a 
weight of approximately 4.73%. The Exchange has chosen to rebalance 
following the close of trading on the quarterly expiration cycle 
because it allows an option contract to be held for up to three months 
without a change in the Index portfolio being effected, while at the 
same time maintaining the equal-dollar weighting feature of the Index. 
If necessary, a divisor adjustment is made at the rebalancing to ensure 
continuity of the Index's value. The newly adjusted portfolio becomes 
the basis for the Index's value on the first trading day following the 
quarterly adjustment.
    As noted above, the number of shares of each component stock in the 
Index portfolio remain fixed between quarterly reviews except in the 
event of certain types of corporate actions such as the payment of a 
dividend other than an ordinary cash dividend, stock distribution, 
stock split, reverse stock split, rights offering, distribution, 
reorganization, recapitalization, or similar event with respect to the 
component stocks.\4\ In a merger or consolidation of an issuer of a 
component stock, if the stock remains in the Index, the number of 
shares of that security in the portfolio may be adjusted, to the 
nearest whole share, to maintain the component's relative weight in the 
Index at the level immediately prior to the corporate action. In the 
event of a stock replacement, the average dollar value of the remaining 
portfolio components in the same weighting tier of the stock being 
replaced (i.e., either the top four stocks by market capitalization as 
of the last rebalance, or the remaining stocks) will be calculated and 
that amount invested in the stock of the new component, to the nearest 
whole share. In all cases, the divisor will be adjusted, if necessary, 
to ensure Index continuity.

    \4\ Telephone conversation between Claire McGrath, Managing 
Director and Special Counsel, Amex, and Francois Mazur, Attorney, 
Office of Market Supervision, Division of Market Regulation, 
Commission, on February 2, 1996.
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    Similar to other stock index values published by the Exchange, the 
value of the Index will be calculated continuously and disseminated 
every 15 seconds over the Consolidated Tape Association's Network B.

D. Maintenance of the Index

    The Exchange will review the Index quarterly,\5\ and maintain it so 
that: (1) The total number of component securities will not increase or 
decrease by more than 33\1/3\% from the number

[[Page 14170]]
of components in the Index at the time of its initial listing, and in 
no event will the Index have fewer than nine components; (2) component 
stocks constituting the top 90% of the Index by weight will have a 
minimum market capitalization of $75 million and the component stocks 
constituting the bottom 10% of the Index by weight will have a minimum 
market capitalization of $50 million; (3) the monthly trading volume 
for each of the past six months \6\ for each component security shall 
be at least 500,000 shares, or, for each of the lowest weighted 
components in the Index that in the aggregate account for no more than 
10% of the weight of the Index, the monthly trading volume shall be at 
least 400,000 shares; (4) no single component will represent more than 
25% of the weight of the Index and the five highest weighted components 
will represent no more than 60% of the Index at each quarterly 
rebalancing; and (5) at least 90% of the index's numerical index value 
and at least 80% of the total number of component securities 
individually will meet the then current criteria for standardized 
option trading set forth in Exchange rule 915;\7\

    \5\ Id.
    \6\ Id.
    \7\ Currently, all Index component securities are the subject of 
standardized options trading.
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    The Exchange will notify promptly Commission staff at any time it 
determines that the Index fails to satisfy any of the foregoing 
maintenance critera. Moreover, in such an event, the Exchange shall not 
open for trading any additional option series, unless such failure is 
determined by the Exchange not to be significant and Commission staff 
concurs in that determination.

E. Expiration and Settlement

    The proposed options on the Index will be European style (i.e., 
exercises permitted at expiration only), and cash settled. Standard 
option trading hours (9:30 a.m. to 4:10 p.m. New York time) will apply. 
Networking Index options will expire on the Saturday following the 
third Friday of the expiration month (``Expiration Friday''). The last 
trading day in an expiring option series normally will be the second to 
last business day preceding the Saturday following the third Friday of 
the expiration month (normally a Thursday). Trading in expiring options 
will cease at the close of trading on the last trading day.
    The Exchange plans to list options series with expirations in the 
three near-term calendar months and in the two additional calendar 
months in the January cycle. In addition, longer term option series 
having up to thirty-six months to expiration may be traded. In lieu of 
such long-term options on a full-value Index level, the Exchange may 
instead list long-term, reduced-value put and call options based on 
one-tenth (\1/10\th) the Index's full value. In either event, the 
interval between expiration months for either a full-value or reduced-
value long-term option will be not less than six months. The trading of 
any long-term options would be subject to the same rules which goven 
the trading of all the Exchange's index options, including sales 
practice rules, margin requirements and floor trading procedures, and 
all options will have European style exercise. Position limits on 
reduced-value long-term Networking Index options will be equivalent to 
the position limits for regular (full-value) Index options and would be 
aggregated with such options (for example, if the position limit for 
the full-value options is 9,000 contracts on the same side of the 
market, then the position limit for the reduced-value options will be 
90,000 contracts on the same side of the market).
    The exercise settlement value for all of the Index's expiring 
options will be calculated based upon the primary exchange regular way 
opening sale prices for the component stocks. In the case of securities 
traded through the NASDAQ/NMS, the first reported regular way sale 
price will be used. If any component stock does not open for trading on 
its primary market on the last trading day before expiration, then the 
prior day's last sale price will be used in the calculation.

F. Exchange Rules Applicable to Stock Index Options

    The Index is deemed to be a Stock Index Option under Rule 901C(a) 
and a Stock Index Industry Group under Rule 900C(b)(1). Exchange rules 
governing margin requirements, position and exercise limits, and 
trading halt procedures applicable to the trading of narrow-based index 
options will apply to options traded on the Index. For example, the 
Exchange expects that the review required by Rule 904C(c) will result 
in a position limit of 9,000 contracts with respect to options on the 
Index. Surveillance procedures currently used to monitor trading in 
each of the Exchange's other index options also will be used to monitor 
trading in options on The Networking Index. With respect to Rule 
903C(b), the Exchange proposes to list near-the-money option series on 
the Index at 2\1/2\ point strike (exercise) price intervals when the 
value of the Index is below 200 points.

G. Surveillance

    Surveillance procedures currently used to monitor trading in each 
of the Exchange's other index options also will be used to monitor 
trading in Index options and full-value and reduced-value Index long-
term options. Further, the Intermarket Surveillance Group (``ISG'') 
Agreement, dated July 14, 1983, as amended on January 29, 1990, will be 
applicable to the trading of options on the Index.\8\

    \8\ ISG was formed on July 14, 1983 to, among other things, 
coordinate more effectively surveillance and investigative 
information sharing arrangements in the stock and options markets. 
See Intermarket Surveillance Group Agreement, July 14, 1983. the 
most recent amendment to the ISG Agreement, which incorporates the 
original agreement and all amendments made thereafter, was signed by 
ISG members on January 29, 1990. See Second Amendment to the 
Intermarket Surveillance Group Agreement, January 29, 1990. The 
members of the ISG are: the Amex; the Boston Stock Exchange, Inc.; 
the Chicago Board Options Exchange, Inc.; the Chicago Stock 
Exchange, Inc.; the National Association of Securities Dealers, Inc. 
(``NASD''); the NYSE; the Pacific Stock Exchange, Inc.; and the 
Philadelphia Stock Exchange, Inc. Because of potential opportunities 
for trading abuses involving stock index futures, stock options, and 
the underlying stock; and the need for greater sharing of 
surveillance information for these potential intermarket trading 
abuses, the major stock index futures exchanges (e.g., the Chicago 
Mercantile Exchange and the Chicago Board of Trade) joined the ISG 
as affiliate members in 1990.
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III. Findings and Conclusions

    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).\9\ Specifically, the 
Commission finds that the trading of Networking Index options, 
including full-value and reduced-value long-term Index options, will 
serve to promote the public interest and help to remove impediments to 
a free and open securities market by providing investors with an 
additional means to hedge exposure to market risk associated with 
stocks in the networking industry.\10\

    \9\ 15 U.S.C. Sec. 78f(b)(5) (1988).
    \10\ Pursuant to Section 6(b)(5) of the Act, the Commission must 
predicate approval of any new option proposal upon a finding that 
the introduction of such new derivative instrument is in the public 
interest. Such a finding would be difficult for a derivative 
instrument that served no hedging or other economic function, 
because any benefits that might be derived by market participants 
likely would be outweighed by the potential for manipulation, 
diminished public confidence in the integrity of the markets, and 
other valid regulatory concerns. In this regard, the trading of 
listed options on the Index will provide investors with a hedging 
vehicle that should reflect the overall movement of the stocks 
representing companies in the networking sector in the U.S. stock 
markets.

[[Page 14171]]

    The trading of options on The Networking Index and on a reduced-
value Index, however, raises several issues relating to index design, 
customer protection, surveillance, and market impact. The Commission 
believes, for the reasons discussed below, that the Amex has addressed 
these issues adequately.

A. Index Design and Structure

    The Commission believes it is appropriate for the Exchange to 
designate the Index as a narrow-based index for purposes of index 
options trading. The Index is comprised of 15 stocks intended to track 
the networking sector of the stock market. The Commission also finds 
that the reduced-value Index is a narrow-based index because it is 
composed of the same component securities as the Index, and merely 
dividing the Index value by ten will not alter its basic character. 
Accordingly, the Commission believes that it is appropriate for the 
Amex to apply its rules governing narrow-based index options to trading 
in the Index options and long-term full-value and reduced-value Index 
options.\11\

    \11\ See supra Section II.F.
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    The Commission also believes that the large capitalizations, liquid 
markets, and relative weightings of the Index's component stocks 
significantly minimize the potential for manipulation of the Index. 
First, the stocks that comprise the Index are actively traded, with a 
mean and median average monthly trading volume for the period between 
July 1995 and December 1995 of 22.9 million and 10.0 million shares, 
respectively. Second, the market capitalizations of the stocks in the 
Index are very large, ranging from a high of $20.9 billion to a low of 
$1.3 billion as of January 2, 1996, with the mean and median being $5.5 
billion and $3.6 billion, respectively. Third, because the index is 
modified equal dollar-weighted, as described above, no one particular 
stock or group of stocks dominates the Index. Specifically, as of 
January 2, 1996, no one stock accounted for more than 13.94% of the 
Index's total value and the percentage weighting of the five highest 
weighted stocks in the Index accounted for 50.63% of the Index's value.
    Fourth, the proposed maintenance criteria will serve to ensure 
that: (1) The Index remains composed substantially of liquid highly 
capitalized securities; and (2) the Index is not dominated by one or 
several securities that do not satisfy the Exchange's options listing 
criteria. Specifically, in considering changes to the composition of 
the Index, 90% of the weight of the Index and 80% of the number of 
components in the Index must at all times comply with the listing 
criteria for standardized options trading set forth in Amex Rule 915.
    The Amex will notify Commission staff promptly at any time the Amex 
determines that the Index fails to satisfy any of the foregoing 
maintenance criteria.\12\ Further, in such an event, the Exchange will 
not open for trading any additional series of Index options or Index 
long-term options unless the Exchange determines that such failure is 
not significant, and Commission staff concurs in the determination.

    \12\ Telephone Conversation between Howard A. Baker, Senior Vice 
President, Derivative Securities, Administration & Research, Amex, 
and Francois Mazur, Attorney, Office of Market Supervision, Division 
of Market Regulation, on March 20, 1996.
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    Finally, the Commission believes that the existing mechanisms to 
monitor trading activity in the component stocks of the Index, or 
options on those stocks, will help deter as well as detect any illegal 
activity.

B. Customer Protection

    The Commission believes that a regulatory system designed to 
protect public customers must be in place before the trading of 
sophisticated financial instruments, such as Index options (including 
full-value and reduced-value long-term Index options), can commence on 
a national securities exchange. The Commission notes that the trading 
of standardized exchange-traded options occurs in an environment that 
is designed to ensure, among other things, that: (1) The special risks 
of options are disclosed to public customers; (2) only investors 
capable of evaluating and bearing the risks of options trading are 
engaged in such trading; and (3) special compliance procedures are 
applicable to options accounts. Accordingly, because the Index options 
and Index long-term full-value and reduced-value options will be 
subject to the same regulatory regime as the other standardized index 
options currently traded on the Amex, the Commission believes that 
adequate safeguards are in place to ensure the protection of investors 
in Index options and full-value or reduced-value Index long-term 
options.

C. Surveillance

    The Commission believes that a surveillance sharing agreement 
between an exchange proposing to list a stock index derivative product 
and the exchange(s) trading the stocks underlying the derivative 
product is an important measure for surveillance of the derivative and 
underlying securities markets. Such agreements ensure the availability 
of information necessary to detect and deter potential manipulations 
and other trading abuses, thereby making the stock index product less 
readily susceptible to manipulation.\13\ In this regard, the Commission 
notes that the Amex, NYSE, and NASD are all members of the ISG.\14\ The 
Commission believes that this arrangement ensures the availability of 
information necessary to detect and deter potential manipulations and 
other trading abuses, thereby making the Index options and full-value 
and reduced-value long-term Index options less readily susceptible to 
manipulation.\15\

    \13\ See Securities Exchange Act Release No. 31243 (September 
28, 1992), 57 FR 45849.
    \14\ See supra note 8.
    \15\ See, e.g., Securities Exchange Act Release No. 31243 
(September 28, 1992), 57 FR 45849 (order approving the listing of 
index options and index LEAPS on the Chicago Board Options Exchange 
Biotech Index).
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D. Market Impact

    The Commission believes that the listing and trading of Index 
options, including full-value and reduced-value Index LEAPS on the 
Amex, will not adversely affect the underlying securities markets. 
First, because of the ``modified equal dollar-weighting'' method that 
will be used, as described above, no one security or group of 
securities represented in the Index will dominate the weight of the 
Index immediately following a quarterly rebalancing. Second, the Index 
maintenance criteria ensure that the Index will be substantially 
comprised of securities that satisfy the Exchange's listing standards 
for standardized options trading, and that one or a few stocks do not 
dominate the Index. Third, the currently applicable 9,000 contract 
position and exercise limits will serve to minimize potential 
manipulation and market impact concerns. Fourth, the risk to investors 
of contra-party non-performance will be minimized because the Index 
options and Index long-term options will be issued and guaranteed by 
the Options Clearing Corporation just like any other standardized 
option traded in the United States.
    Lastly, the Commission believes that settling expiring Networking 
Index options (including full-value and reduced-value long-term Index 
options) based on the opening prices of component securities is 
reasonable and consistent with the Act. As has been noted previously, 
valuing index options for exercise settlement on expiration based on 
opening rather than closing

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prices of index component securities may help to reduce adverse effects 
on markets for such securities.\16\

    \16\ See Securities Exchange Act Release No. 30944 (July 21, 
1992), 57 FR 33376 (July 28, 1992).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\17\ that the proposed rule change (SR-Amex-96-03), as amended, is 
approved.

    \17\ 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.\18\

    \18\ 17 CFR 200.30-3(a)(12) (1994).
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Jonathan G. Katz,
Secretary.
[FR Doc. 96-7704 Filed 3-28-96; 8:45 am]
BILLING CODE 8010-01-M