[Federal Register Volume 63, Number 248 (Monday, December 28, 1998)]
[Notices]
[Pages 71534-71535]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-34253]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-40814; File No. SR-NASD-98-78]


Self-Regulatory Organizations; Order Granting Approval to 
Proposed Rule Change by the National Association of Securities Dealers, 
Inc. Relating to the Equity Option Hedge Exemption

December 21, 1998.

I. Introduction

    On October 15, 1998, the National Association of Securities 
Dealers, Inc. (``NASD'' or ``Association''), through its wholly owned 
subsidiary NASD Regulation (``NASD Regulation''), filed with the 
Securities and Exchange Commission (``Commission'') a proposed rule 
change pursuant to Section 19(b)(1) of the Securities Exchange Act of 
1934 (``Exchange Act''),\1\ and Rule 19b-4 thereunder.\2\ In its 
proposal, NASD Regulation seeks to make permanent the Equity Option 
Hedge Exemption, which has been operating as a pilot program since 
1990. Notice of the proposal was published in the Federal Register on 
November 16, 1998 (``Notice'').\3\ No comments were received. This 
order approves the proposal.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Exchange Act Release No. 40652 (Nov. 9, 1998), 63 FR 
63764 (Nov. 16, 1998) (File No. SR-NASD-98-78).
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II. Description of the Proposal

    The purpose of the proposed rule change is to make permanent the 
NASD's Equity Option Hedge Exemption program (``Hedge Exemption''), 
which has been operating on a pilot basis since 1990. NASD Rule 
2860(b)(3) provides that the position limits for equity options are 
determined according to a five-tiered system in which more actively 
traded stocks with larger public floats are subject to higher position 
limits. Under the NASD rules, the current basic position limits are as 
follows. For standardized equity options,\4\ the current basic position 
limits are: 4,500, 7,500, 10,500, 20,000 and 25,000 contracts. For 
conventional equity options,\5\ the current basic position limits are 
three times the standardized equity options position limits, i.e., 
13,500, 22,500, 31,500, 60,000 and 75,000 contracts. NASD rules do not 
specifically govern how a particular equity option falls within one of 
the five position limit tiers. Rather, the NASD's position limit rule 
provides that the position limit established by an options exchange for 
a particular equity option is the applicable position limit for 
purposes of the NASD's rule.\6\
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    \4\ Standardized equity options are exchange-traded options 
issued by the Options Clearing Corporation (``OCC'') that have 
standard terms with respect to strike prices, expiration dates and 
the amount of the underlying security.
    \5\ A conventional option is any option contract not issued, or 
subject to issuance by, the OCC.
    \6\ For equity options that do not trade on an options exchange, 
the NASD's position limit rule provides that the limit for 
conventional equity options shall be three times the basic limit of 
4,500 contracts, such as 13,500 contracts, unless the member can 
demonstrate to the Association that the underlying security meets 
the standards for higher limits and the initial listing standards 
for standardized options trading.
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    The Hedge Exemption provides for an automatic, limited exemption 
from position limits \7\ and exercise limits \8\ for equity options 
that are hedged using one of the four most commonly used hedge 
positions: (1) Long stock and short call; (2) long stock and long put; 
(3) short stock and long call; and (4) short stock and short put. The 
NASD rules also specify how an options contract must be hedged. To be 
properly hedged, the options contract must be: (i) hedged by 100 shares 
of stock, (ii) hedged by securities that are readily convertible into, 
or economically equivalent to, such stock,\9\ or (iii) in the case of 
an adjusted options contract, hedged by the number of shares 
represented by the adjusted contract. Under the Hedge Exemption, the 
maximum standardized equity option position (combining hedged and 
unhedged positions) is three times the basic position limit level for 
standardized options, i.e., 13,500, 22,500, 31,500, 60,000 or 75,000 
contracts. Additionally, the maximum conventional equity option 
position (combining hedged and unhedged positions) is three times the 
basic position level for conventional equity options, i.e., 40,500, 
67,500, 94,500, 180,000 or 225,000 contracts.
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    \7\ Position limits impose a ceiling on the number of options 
contracts of each options class on the same side of the market that 
can be held or written by an investor or group of investors acting 
in concert.
    \8\ Exercise limits restrict the number of options contracts 
that an investor or group of investors acting in concert can 
exercise within five consecutive business days. Under NASD Rules, 
exercise limits correspond to position limits, such that investors 
in options classes on the same side of the market are allowed to 
exercise, during any five consecutive business days, only the number 
of options contracts set forth as the applicable position limits for 
those options classes.
    \9\ The Commission notes that the NASD determines on a case-by-
case basis whether an instrument that is being used as the basis for 
an underlying hedged position is readily and immediately convertible 
into the security underlying the corresponding option position. In 
this regard, the NASD generally finds that an instrument which will 
become convertible into a security at a future date, but which is 
not presently convertible, is not a ``convertible'' security for 
purpose of the equity option position limit hedge exemption until 
the date it becomes convertible. In addition, if the convertible 
security used to hedge an options position is called for redemption 
by the issuer, the security would have to be converted into the 
underlying security immediately or the corresponding options 
position reduced accordingly.
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III. Discussion

    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 association, and, in 
particular, the requirements of Section 15A.\10\ Specifically, the 
Commission believes that the NASD's equity options position limit hedge 
exemption will accommodate the needs of investors and market 
participants while at the same time furthering investor protection and 
the public interest.\11\
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    \10\ 15 U.S.C. 78o-3(b)(6).
    \11\ In approving the proposal, the Commission has considered 
its impact on efficiency, competition, and capital formation. 15 
U.S.C. 78c(f).
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    The Commission believes that the Hedge Exemption is an important 
component of the options position limit rules and should be continued 
on a permanent basis. The Hedge Exemption is a necessary tool for 
market participants to manage their market exposure by allowing them 
the flexibility to hold larger options positions in cases where such 
positions are hedged. The Commission further believes that the Hedge 
Exemption provides 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.
    The Commission notes that the Hedge Exemption has been operating on 
a pilot basis since 1990. NASD Regulation has had eight years of 
experience administering and monitoring the program. The Commission 
believes that NASD Regulation has adequate rules in place to surveil 
the proposed hedge exemption. Specifically, NASD rules require each 
member to report options positions of any account which has established 
an aggregate position of 200

[[Page 71535]]

or more option contracts of the put class and the call class on the 
same side of the market covering the same underlying security.\12\ 
Finally, the Commission believes that approval of the NASD's Hedge 
Exemption on a permanent basis is appropriate in order to achieve 
parity with the exchange-trade options markets.\13\
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    \12\ See Rule 2860(b)(5).
    \13\ See, e.g., American Stock Exchange Rule 904; Chicago Board 
Options Exchange Rule 4.11.
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\14\ that the proposed rule change (SR-NASD-98-78) is approved.

    \14\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\15\
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    \15\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-34253 Filed 12-24-98; 8:45 am]
BILLING CODE 8010-01-M