[Federal Register Volume 62, Number 188 (Monday, September 29, 1997)]
[Notices]
[Pages 50966-50970]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-25688]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39115; File No. SR-CBOE-96-75]


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 Chicago 
Board Options Exchange, Incorporated Relating to the Listing and 
Trading of Packaged Butterfly Spreads

September 22, 1997.

I. Introduction

    On December 16, 1996, the Chicago Board Options Exchange, Inc. 
(``CBOE''

[[Page 50967]]

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 list for trading Packaged Butterfly Spreads 
based upon the S&P 100 and the S&P 500 Indexes.
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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 February 4, 1997.\3\ The Exchange filed with 
the Commission Amendment Nos. 1,\4\ 2,\5\ and 3 \6\ to the proposal on 
March 18, May 2, and June 5, 1997, respectively.
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    \3\ See Securities Exchange Act Release No. 38213 (January 28, 
1997), 62 FR 5265 (February 4, 1997).
    \4\ In Amendment No. 1, the Exchange provided a new definition 
for ``butterfly spread interval'' and several revisions to the 
margin rules, as described more fully herein. See Letter from Tim 
Thompson, Senior Attorney, CBOE, to John Ayanian, Special Counsel, 
Office of Market Supervision (``OMS''), Division of Market 
Regulation (``Market Regulation''), Commission, dated March 18, 1997 
(``Amendment No. 1'').
    \5\ In Amendment No. 2, the Exchange amended its margin rules as 
they apply to spread positions where the long index option contract 
is a Packaged Butterfly Spread. Amendment No. 2, also verified that 
CBOE will list and add series for Packaged Butterfly Spreads in 
accordance with Rule 24.9, Interpretation and Policy .01(c). 
Finally, in Amendment No. 2, the Exchange indicated that position 
limits for Packaged Butterfly Spreads based on the S&P 500 and 100 
will be the same as existing position limits for the respective 
index options and will be aggregated with other option contracts on 
the same index. See Letter from William M. Speth, Sr. Research 
Analyst, Product Development, Research Department, CBOE, to Howard 
L. Kramer, Senior Associate Director, OMS, Market Regulation, 
Commission, dated May 2, 1997 (``Amendment No. 2'').
    \6\ In Amendment No. 3, the Exchange made several technical, 
non-substantive changes to the proposal. In addition, the Exchange 
made changes to the margin rules. In particular, the Exchange 
amended its margin rules (and modified Amendment No. 2), to indicate 
that margin treatment for spread positions set forth in Rule 
24.11(c)(1)(B) do not apply for spread positions where one or both 
positions comprising the spread are Packaged Butterfly Spreads. As 
proposed in new Rule 24.11(c)(1)(D), if a spread position involves a 
Packaged Butterfly Spread, as either the long options position or 
the short options position, the minimum margin required on such a 
position will be the full purchase price on the long position plus 
the margin required in Rule 24.11(b) for the short position. The 
Exchange also clarified its policy for changing butterfly spread 
intervals, as described more fully herein. See Letter from Eileen 
Smith, Director, Product Development, Research Department, CBOE, to 
John Ayanian, Special Counsel, OMS, Market Regulation, Commission, 
dated June 4, 1997 (``Amendment No. 3'').
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    No comment letters were received on the proposed rule change. This 
order orders the Exchange's proposal, as amended.

II. Description of the Proposal

    The Exchange proposes to list for trading Packaged Butterfly 
Spreads based upon the S&P 100 index and the S&P 500 index. A Packaged 
Butterfly Spread is a packaged European-style option that replicates 
the behavior and payout of a butterfly spread \7\ composed of standard 
index option contracts. The Exchange proposes that the Packaged 
Butterfly Spreads on the S&P 100 and 500 indexes will have a multiplier 
of 100. Because Packaged Butterfly Spreads composed of puts are 
identical to those composed of calls the Exchange will not list both 
puts and calls; there will be only one call option listed for each 
strike price and butterfly interval.
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    \7\ A butterfly spread is a combination of four option positions 
of the same type (put or call) and the same expiration on thee same 
underlying interest using three different strike prices. For 
example, using only calls, a butterfly spread would consist of 
buying one call at the lowest strike price, selling two calls at the 
middle strike price and buying one call at the highest strike price. 
A butterfly spread with a butterfly spread interval of 30 might 
consist of one long December (expiration month) 670 (strike price) 
call option, two short December 700 call options, and one long 
December 730 call option.
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    The Exchange believes Packaged Butterfly Spreads on the Indexes 
will provide advantages to the investing public that are not provided 
for by standard index options. First, the Exchange believes Packaged 
Butterfly spreads offer investors a relatively low risk security which 
results because Packaged Butterfly Spreads, by their nature, have a 
maximum gain and loss that can be realized regardless of the movement 
in the index level. Packaged Butterfly Spreads allow investors to 
profit from trendless markets with limited risk. Second, the 
``packaging'' of a strategy of four option positions into one option 
product reduces transaction-related expenses because the investor will 
only have to enter into one transaction. Third, in the case of Packaged 
Butterfly Spreads overlying the S&P 100, the investor will have the 
opportunity to invest in an option product that has European-style 
exercise.\8\ Standard S&P 100 options (``OEX'') have American-style 
exercise.\9\ The Exchange expects Packaged Butterfly Spreads to be 
supported enthusiastically by market-makers because butterfly spread 
trading is a familiar strategy to professional traders and the Packaged 
Butterfly Spreads can be easily incorporated into the overall risk 
profile of the market-maker's trading strategy in standard index 
options.
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    \8\ Only European-style Packaged Butterfly Spreads will be 
available to investors. A European-style option is one that may be 
exercised only during a limited period of time prior to expiration.
    \9\ An American-style option is one that may be exercised at any 
time prior to expiration.
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    The Exchange proposes to amend Rule 24.1 to describe the new 
product \10\ as well as the term ``butterfly spread interval''.\11\
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    \10\ See Amendment No. 3, supra note 6.
    \11\ Specifically, the ``butterfly spread interval'' means a 
value specified by the Exchange which, when added to the exercise 
price and subtracted from the exercise price defines a range of 
index values over which the option has an exercise settlement amount 
greater than $0. See Amendment No. 1, supra note 4.
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Position and Exercise Limits

    The Exchange is proposing position limits for Packaged Butterfly 
Spreads overlying the S&P 100 of 25,000 contracts. The Exchange is 
proposing position limits for Packaged Butterfly Spreads overlying the 
S&P 500 of 100,000 contracts. For position limit purposes, Packaged 
Butterfly Spreads will be aggregated with option contracts on the same 
index. These position limits are consistent with the position limits 
that have been established for standard index options on the S&P 100 
and 500 indexes, respectively. The exercise limits for Packaged 
Butterfly Spreads will be equal to the position limits set forth above 
in accordance with the terms of CBOE Rule 24.5.

Margin

    With respect to margin, risk exposure is limited in Packaged 
Butterfly Spreads, and therefore, the maximum margin requirements 
should not exceed the maximum exposure amount which, for each Packaged 
Butterfly Spread option contract equals the butterfly spread interval 
times the index multiplier. The proposed amendments state that the 
maximum margin required for a Packaged Butterfly Spread option contract 
carried in a short position shall not exceed this maximum exposure 
amount. In addition, margin requirements for spread positions set forth 
in Rule 24.11(c)(1)(B) does not apply for spread positions where one or 
both positions comprising the spread are Packaged Butterfly Spreads. If 
a spread position involves a Packaged Butterfly Spread, as either the 
long position or the short position, the minimum margin required on 
such a position will be the full purchase price on the long position 
plus the margin required in Rule 24.11(b) for the short position.\12\
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    \12\ See Rule 24.11(c)(a)(D) and Amendment No. 3, supra note 6.
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    Listing of Series. The Exchange expects to list contracts having 
butterfly spread intervals of ranging from 10 to 50 points. The 
Exchange does not intend to simultaneously open series with more than 
one butterfly spread interval. However, the CBOE may introduce a

[[Page 50968]]

new series with a new butterfly spread interval with a new ticker 
symbol resulting in a brief period (1 or 2 months) of open series with 
two butterfly spread intervals. Initially, the Exchange intends to list 
an at-the-money and various strikes around the at-the-money in the 
first two near-term months in accordance with Rule 24.9, Interpretation 
and Policy .01(c).\13\ New strikes will be added when the underlying 
trades through the highest or lowest strike available.
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    \13\ See Amendment No. 2, supra note 5.
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Settlement

    The expiration date for Packaged Butterfly Spreads will be the 
Saturday immediately following the third Friday of the expiration 
month. Exercise will result in the delivery of cash on the business day 
following expiration. The exercise settlement amount is equal to the 
greater of: (1) Butterfly spread interval minus the difference between 
the index settlement value and the midpoint of the butterfly multiplied 
by the multiplier ($100), and (2) $0. Packaged Butterfly Spreads will 
have a European-style of exercise.

Miscellaneous

    CBOE will use the same surveillance methods it currently employs 
with respect to their broad-based index options.
    CBOE has also been informed that the Options Price Reporting 
Authority recently added another outgoing high speed line from OPRA 
processor and thus, has the capacity to support the new series 
associated with the listing of Packaged Butterfly Spreads.\14\
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    \14\ See Memorandum from Joe Corrigan, OPRA, to Eileen Smith, 
CBOE, dated November 21, 1996.
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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.\15\ 
Moreover, the Exchange's proposal to list and trade Package Butterfly 
Spreads on the S&P 100 and S&P 500 indexes 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.\16\ Specifically, the Commission finds that the Packaged 
Butterfly Spreads are an innovative financial product that will provide 
investors with additional choices and flexibility in their use of 
derivatives.\17\ In addition, Packaged Butterfly Spreads 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 
Packaged Butterfly Spreads, the option writer's (holder's) maximum loss 
(gain) is established at the time of the investment by the option's 
butterfly spread interval. Accordingly, Packaged Butterfly Spreads 
permit investors to participate in the options market at a known cost. 
In addition, the Commission believes that Packaged Butterfly Spreads, 
which replicate the combination of four separate option positions on 
the same underlying interest and expiration, likely will benefit 
investors by providing them with a more efficient and cost effective 
method of executing spread transactions.
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    \15\ 15 U.S.C. 78f(b)(5).
    \16\ In approving this rule, the Commission notes that it has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \17\ 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 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 Packaged Butterfly Spreads on the S&P 
500 and 100 will provide investors with another hedging vehicle that 
should reflect the overall movement of the U.S.-listed stock market.
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    The Commission also finds that the specific rules proposed by the 
CBOE to accommodate Packaged Butterfly Spreads are consistent with the 
Act.\18\ Specifically, the Commission believes that it is reasonable 
for the Exchange to set a butterfly spread interval range from 10 to 50 
points. In response to the Commission's concerns about investor 
confusion by having series of Packaged Butterfly Spreads simultaneously 
open with different butterfly spread intervals, the Exchange does not 
intend to simultaneously open series with more than one butterfly 
spread interval. However, the CBOE may introduce a new series with a 
new butterfly spread interval with a new ticker symbol resulting in a 
brief period (1 or 2 months) of open series with two butterfly spread 
intervals.\19\ The Commission notes that the Exchange may submit a 
``noncontroversial filing'' pursuant to Section 19(b)(3)(A) of the Act 
and Rule 19b-4(e)(6) thereunder if it decided to change the present 
butterfly spread range (currently 10 to 50 points) and the proposal 
does not raise any other regulatory issues.
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    \18\ The Commission notes that CBOE Rule 24.1, as amended, 
defines Packaged Butterfly Spreads. Because the current Exchange 
proposed definition is limited to Packaged Butterfly Spreads on the 
S&P 500 and 100 Indexes, the Exchange is required to submit a rule 
filing pursuant to Section 19(b) of the Act in order to list 
Packaged Butterfly Spreads on another stock index or individual 
security.
    \19\ The Exchange represents that it would not allow margin 
offset, pursuant to Rule 24.11(c), between spread with different 
spreads intervals. See Amendment No. 3, supra note 6.
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    The Commission also notes that Packaged Butterfly Spreads on the 
S&P 500 and S&P 100 indexes will be subject to the same position and 
exercise limit requirements that currently apply to S&P 500 and S&P 100 
index options, respectively. In particular, Packaged Butterfly Spreads 
on the S&P 500 will be aggregated with all other S&P 500 index options, 
subject to a 100,000 contract limit under Rule 24.4(b). Packaged 
Butterfly Spreads on the S&P 100 index will be aggregated with all 
other S&P 100 index options, subject to a 25,000 contract limit under 
Rule 24.4(b).
    The Commission believes that the proposed margin treatment for 
Packaged Butterfly Spreads in cash and margin accounts is consistent 
wit the Act. Specifically, the Commission believes that, similar to 
short capped options positions,\20\ it is reasonable to permit short 
Packaged Butterfly Spreads positions in a cash account so long as the 
maximum exposure (the butterfly spreads interval) 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 that the proposed margin requirements for Packaged 
Butterfly Spreads in margin accounts is reasonable because they are 
virtually identical to the margin requirements for traditional short 
stock index options positions held in margin accounts, except 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 
way because the margin would cover 100% of the writer's exposure, 
thereby requiring no additional margin calls.
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    \20\ See Securities Exchange Act Release No. 29865 (October 28, 
1991), 56 FR 56255 (November 1, 1991).
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    The Commission also believes it is reasonable to require for any 
spread position involving a Packaged Butterfly Spread a minimum margin 
deposit equal to the full purchase price on the long position plus the 
margin required in Rule 24.11(b) for the short position.\21\ 
Accordingly, the Commission believes it is reasonable under such 
circumstances to prohibit application of margin

[[Page 50969]]

requirements for spread positions involving a Packaged Butterfly Spread 
because the required margin deposit would not always cover 100% of the 
writer's exposure. For example, a spread involving a long 670 S&P 500 
index call option and a short 650 Packaged Butterfly Spread on the S&P 
500, with a butterfly spread interval of 50, the margin deposit 
requirement under the margin rule for spread transactions would be the 
lesser of (1) The difference in aggregate exercises prices 
((670-650) x 100=$2,000) and (2) the butterfly spread interval times 
the multiplier (i.e., 50 x 100=$5,000). The margin deposit requirement 
under the spread rule, if allowed, would be $2,000. The writer's 
maximum exposure (when the current index level is 650), however, is 
$3,000.\22\ For this spread position, the margin requirement under 
proposed CBOE Rule 24.11(c)(1)(D) will be the full purchase price of 
the long position (premium x $100) plus the butterfly spread interval 
times the index multiplier (50 x $100) of the short position.
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    \21\ See supra note 12.
    \22\ The writer's maximum exposure of this spread position is 
determined as follows:
    short loss-long gain=maximum exposure
    $5,000-(670-650) x 100
    $5,000-(20) x 100
    $500-$2,000=($3,000)
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    In summary, the Commission believes that the Packaged Butterfly 
Spreads on the S&P 500 and S&P 100 Indexes will provide investors with 
additional choices and flexibility in their use of derivatives and 
offer both holders and writers of options a means to participate in the 
options markets at a predetermined maximum gain or loss. Further, the 
Commission notes that in order to promote investor protection and to 
ensure adequate disclosure in connection with Packaged Butterfly 
Spreads, the rules pertaining to standardized options and the 
requirements of Exchange Act Rule 9b-1 will apply to trading in 
Packaged Butterfly Spreads. The Commission believes it is important to 
provide investors with information regarding the rights and 
characteristics of Packaged Butterfly Spreads. In this regard, Packaged 
Butterfly Spread investors will receive a special supplement to the 
Options Clearing Corporation's (``OCC'') Options Disclosure Document 
(``ODD Supplement'') explaining in detail the risks and characteristics 
of Packaged Spreads.\23\
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    \23\ In reviewing any disclosure materials submitted, the 
Commission intends to assure that the materials specifically 
describe the risks and characteristics associated with trading 
Packaged Spreads. Trading trading of Packaged Butterfly Spreads is 
Packaged Spreads. The trading of Packaged Butterfly Spreads is 
expressly contingent upon the Commission's approval of such an ODD 
supplement.
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    The Commission finds good cause for approving Amendment Nos. 1, 2, 
and 3 prior to the thirtieth day after the date of publication of 
notice of filing thereof in the Federal Register. Specifically, 
Amendment No. 1 to CBOE's proposal set forth a new definition for 
``butterfly spread interval'' and several technical revisions to the 
margin rules, as described above.
    Amendment No. 2 to CBOE's proposal: (1) Verifies that CBOE will 
list and add series for Packaged Butterfly Spreads in accordance with 
Rule 24.9, Interpretation and Policy .01(c); and (2) sets position 
limits for Packaged Butterfly Spreads based on the S&P 500 and 100 to 
equal existing position limits for the respective index options.\24\
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    \24\ As described above, Packaged Butterfly Spreads on the S&P 
500 and 100 indexes will be aggregated with other options on the 
same index.
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    The first change described above is clarifying in nature and will 
prevent undue proliferation of options series on Packaged Butterfly 
Spreads. The Commission believes the Exchange's proposed reduction in 
position limits from those originally proposed presents no new 
regulatory issues and can be approved on an accelerated basis. Further, 
the originally proposed higher position limits were subject to the full 
21-day comment period without any comments being received by the 
Commission.
    Amentment No. 3 to CBOE's proposal also makes several technical 
non-substantive changes. In addition, the Exchange amended the 
definition of Packaged Butterfly Spread to further clarify that the 
product is intended to replicate the behavior of the combination of 
four separate options, as described above. Finally, Amendment No. 3 
provides that margin requirements for spread positions set forth in 
Rule 24.11(c)(1)(B) do not apply for spread positions where one or both 
positions comprising the spread are Packaged Butterfly Spreads. \25\ 
The Commission believes that the proposed changes to the margin 
requirements present no new regulatory issues and further strengthens 
the Exchange's proposal by ensuring that adequate margin will be 
deposited by those with positions involving Packaged Butterfly Spreads.
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    \25\ Accordingly, this proposed amendment eliminates the 
provision in Amendment No. 2 which would have allowed spread 
positions involving long Packaged Butterfly Spread positions to 
receive margin treatment under the spread rule. See Amendment No. 3, 
supra note 6.
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    The Commission believes that the changes proposed in Amendment Nos. 
1, 2, and 3, unless otherwise stated above, merely clarify in the rule 
text what was originally proposed by the Exchange and will help to 
ensure that investors understand the specifications and trading 
characteristics of the Packaged Butterfly Spread contracts. In 
addition, the Commission notes that the original proposal was published 
for the full 21-day comment period without any comments being received 
by the Commission. Moreover, the Commission believes that the foregoing 
amendments raise no new regulatory issues.
    Accordingly, the Commission finds 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 proposed rule change, on an accelerated basis.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning Amendment Nos. 1, 2, and 3 to the proposed rule 
change. 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. Sec. 552, will 
be available for inspection and copying at the Commission's Public 
Reference Section, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of such filing will also be available for inspection and copying 
at the principal office of the CBOE. All submissions should refer to 
SR-CBOE-96-75 and should be submitted by October 20, 1997.

V. Conclusion

    Based upon the aforementioned factors, the Commission finds that 
the proposed changes relating to the listing and trading of Packaged 
Butterfly Spreads on the S&P 500 and 100 are consistent with the 
requirements of Section 6(b)(5) and the rules and regulations 
thereunder. The initiation of Packaged Butterfly Spread trading, 
however, is conditioned upon the issuance of an order approving an ODD 
Supplement, pursuant to Rule 9b-1 of the Act.

[[Page 50970]]

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\26\ that the proposed rule change (File No. SR-CBOE-96-75), is 
amended, is approved.
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    \26\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\27\
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    \27\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-25688 Filed 9-26-97; 8:45 am]
BILLING CODE 8010-01-M