[Federal Register Volume 61, Number 192 (Wednesday, October 2, 1996)]
[Notices]
[Pages 51478-51479]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-25223]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37732; File No. SR-CBOE-96-29]
Self-Regulatory Organizations; Order Approving a Proposed Rule
Change by the Chicago Board Options Exchange, Incorporated, Relating to
the Exercise of American-style Index Options
September 26, 1996.
I. Introduction
On April 26, 1996, the Chicago Board Options Exchange, Incorporated
(``CBOE'' or ``Exchange'') filed a proposed rule change with 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\ to adopt new CBOE Rule
24.18 which prohibits the exercise of an American-style index option
series after the holder has entered into an offsetting closing sale
(writing) transaction.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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Notice of the proposal was published for comment and appeared in
the Federal Register on August 15, 1996.\3\ No comment letters were
received on the proposed rule change. This order approves the
Exchange's proposal.
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\3\ See Securities Exchange Act Release No. 37540 (August 8,
1996), 61 FR 42455.
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II. Description of the Proposal
As noted in CBOE's Regulatory Circular RG 96-11,\4\ the rules and
procedures of The Options Clearing Corporation (``OCC'') permit a
holder of an American-style option \5\ to exercise that options at any
time up to the exercise cut-off time on any day, other than the final
trading day, even if the holder had entered into an offsetting closing
sale transaction earlier that day. This result stems from the fact that
on such days OCC processes opening purchase transactions and exercises
before it processes closing sales transactions, so that option
purchasers remain holders of their options on OCC's books for the
purpose of exercise without regard to their closing sales that day.
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\4\ See Securities Exchange Act Release No. 36797 (January 31,
1996), 61 FR 4691 (February 7, 1996) (File No. SR-CBOE-96-03).
\5\ An American-style option may be exercised at any time prior
to expiration.
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The Exchange is concerned that this result may be confusing to
investors--because it may give the appearance that investors are able
to exercise the same options which they have previously sold--and lead
to a perception that this result is unfair to writers of American-style
index options that are in the money by subjecting them to a potentially
increased ``timing risk'' of the type described under ``Special Risks
of Index Options'' on pages 73-74 of the risk disclosure document
entitled ``Characteristics and Risks of Standardized Options''
(February 1994).\6\
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\6\ This document is generally known as the Options Disclosure
Document or ``ODD''.
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Additionally, the Exchange believes that the average retail
customer might not understand how investors could exercise options
which they believed they no longer owned. The Exchange represents that,
during the period from November 1993, through December 1995, almost all
of the gross exercises in customers' accounts were effected at one
clearing firm on behalf of a single customer that is a foreign
professional trading account. Accordingly, the Exchange believes that
retail customers might view the gross exercise ability as giving
professional traders an unfair advantage over retail customers and that
such perception could lead to the diminished popularity of Standard and
Poor's 100 (``OEX'') index options for retail customers.\7\
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\7\ See Letter from Michael L. Meyer, Attorney, Schiff Hardin &
Waite, to John Ayanian, Attorney, Office of Market Supervision
(``OMS''), Division of Market Regulation (``Market Regulation''),
Commission, dated June 17, 1996. OEX index options are the only
American-style index options currently traded at the CBOE. All other
CBOE index option are European-style, with exercise only permitted
upon their expiration.
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To eliminate this possible perception of unfairness, the proposed
rule would prohibit CBOE members from effecting an exercise of an OEX
options series (or any other American-style index option series
subsequently listed by the Exchange), whether on the member's own
behalf or on behalf of a customer, if the member knew or had reason to
know that the exercise was for more option contracts than the ``net
long position'' of the account for which the exercise is to be made.
For this purpose, the ``net long position'' in an account is the net
position of the account in options of a given series at the opening of
business of the day of exercise, plus the total number of such options
purchased on that day in opening purchase transactions up to the time
of exercise, less the total number of such options sold on that day in
closing sale transactions up to the time of exercise.
In order to prevent persons from circumventing the proposed rule by
designating a sale as ``opening'' so as to maintain a net long position
capable of being exercised, and then redesignating the sale as
``closing'' by means of an adjustment later in the day if in fact the
long position has not been exercised, the rule would prohibit a member
from adjusting the designation of an opening transaction to a closing
transaction except to remedy mistakes or errors made in good faith.
A market maker's transactions are not required to be marked as
opening or closing. Rather, a market maker's purchase and sales
transactions are netted by OCC every day after exercises are processed.
As a result, it is impossible to tell whether a particular transaction
by a market maker is intended as an opening or closing transaction.
Under OCC's processing procedures, unmarked market makers' transactions
are in effect treated as opening transactions prior to the processing
of exercises and as closing transactions thereafter. For the purpose of
applying the prohibition of the proposed rule, every market maker
transaction would be treated as a closing transaction to the extent the
market maker has pre-existing positions (including positions resulting
from transactions effected earlier that day) which could be netted
against the transaction. For example, if a market maker is long 10
option contracts of a series and sells 15 contracts of that series, the
sale will be deemed, under the proposed rule, to be a closing sale
transaction for 10 contracts and an
[[Page 51479]]
opening sale transaction for 5 contracts, resulting in a net short
position of 5 contracts. If the market maker then purchases 20
contracts, the purchase will be deemed a closing purchase for 5
contracts and an opening purchase for 15 contracts, resulting in a net
long position 15 contracts. Under the proposed rule, the market maker
would be permitted to exercise only those 15 contracts. In the absence
of the proposed rule, the market maker would have been able to exercise
30 contracts, representing his gross long position, before netting
against this position the 15 contracts sold.
The Exchange notes that the proposed rule is not intended to affect
OCC's processing rules and procedures. If a member submitted an
exercise notice to OCC in violation of the proposed CBOE rule, the
exercise would be processed by OCC in accordance with its procedures.
In that case, the proposed CBOE rule would be enforced solely through
the Exchange's disciplinary procedures.
The Exchange emphasizes that the proposed rule has been adopted to
eliminate the perception that a holder's ability to exercise options
that had been the subject of closing transactions might create enhanced
risk to writers of OEX options. However, it is not clear that the
writers of in-the-money OEX options will, in fact, be subject to less
risk as the result of the proposed rule. Such writers should continue
to anticipate that they could be assigned an exercise of their options
positions, especially as expiration approaches. (For example, the
proposed rule would not prohibit the exercise of an OEX option held in
a net long position before--even seconds before--an opening sales
transaction in that option has been effected.) It is possible that the
early exercise of OEX options will continue at the same level after the
proposed rule becomes effective as before.
Upon the effectiveness of the proposed rule, the Exchange would
modify Regulatory Circular RG 96-11 to describe the proposed rule.
Three examples were given in the Regulatory Circular as originally
published on January 17, 1996. These three examples would be modified
to read as follows (italicized language is proposed to be added;
language in brackets is proposed to be deleted):
Example 1: Investor X is long 15 call option contracts of a series
at the opening of a trading day other than the final trading day.
During that day, X purchases 20 contracts of that series in opening
purchase transactions and sells 10 contracts in closing sale
transactions. X will be able under OCC's rules to exercise 35 contracts
of that series that day. However, in the case of American-style index
options only (i.e., OEX options), CBOE Rule 24.18 would prohibit a
member who knows or has reason to know of the closing sale transactions
from exercising on X's behalf more than the net long position of 25
contracts at any time at or after the closing sale of 10 contracts.
Example 2: Investor Y is short 20 call option contracts of a series
at the opening of such a trading day. During the day, Y purchases 20
contracts of that series in opening purchase transactions. Y will be
able to exercise 20 contracts of that series that day, and will remain
short the 20 contracts. However, in the case of OEX option contracts,
if Y's transactions had been effected in a market-marker's account, the
purchase would have been deemed to have been a closing transaction for
the purposes of CBOE Rule 24.18 and would have been offset by Y's short
position, resulting in no net long position to exercise.
Example 3: Market-maker Z is short 100 call options contracts at
the opening of that trading day. During the day, Z purchases 100
contracts and sells 100 contracts of that series[, and Z does not mark
the transactions as opening or closing]. Z will be able to exercise 100
contracts of that series that day under OCC's rules. However, in the
case of OEX option contracts, CBOE Rule 24.18 would prohibit Z from
exercising any contracts without regard to the sale transactions, since
the purchase transactions would be deemed to be closing transactions,
and would be netted against his beginning short position, resulting in
no net long position to exercises.
III. Commission Finding 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) of the Act.\8\
Specifically, the Commission finds that the Exchange's proposal strikes
a reasonable balance between the Commission's mandates under Section
6(b)(5) to remove impediments to and perfect the mechanism of a free
and open market and a national market system, while protecting
investors and the public interest.
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\8\ 15 U.S.C. 78f(b)(5).
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The Commission believes that it is reasonable for the Exchange to
conclude that permitting holders of American-style index options series
to exercise positions greater than their ``net long'' position, as
described above, may lead to a possible perception of unfairness to
retail investors and American-style index option writers. Effectively,
the proposal creates an option exercise restriction upon holders of
American-style index options, preventing such holders from exercising
positions in excess of their net long position. The Commission believes
that the imposition of a restriction on exercise requires a careful
balancing of the Exchange's need for such a restriction with the impact
that such a restriction will impose upon options market participants,
including market professionals and individual investors.
Based on representations of the Exchange, the Commission believes
that the proposed limited restriction on exercise is reasonable and
should not adversely impact (1) the options exercise practices of
existing OEX options market participants, (2) market participants'
ability to utilize the options markets, or (3) trading in American-
style index options generally. Particularly, the Commission believes
that the Exchange has reasonably balanced the impact of the proposed
rule change on option holders with its desire to eliminate the possible
perception of unfairness on behalf of retail customers and American-
style index option writers.
The Commission expects the Exchange to promptly modify Regulatory
Circular RG96-11 to describe the proposed rule and distribute the new
circular to its membership. Moreover, the Commission notes that the
CBOE has established surveillance guidelines that should help to ensure
compliance with the new policy.
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\9\ that the proposed rule change (File No. SR-CBOE-96-29) is
approved.
\9\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\10\
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\10\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-25223 Filed 10-1-96; 8:45 am]
BILLING CODE 8010-01-M