[Federal Register Volume 66, Number 160 (Friday, August 17, 2001)]
[Notices]
[Pages 43274-43277]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-20764]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44681; File No. SR-CBOE-00-12]


Self-Regulatory Organizations; Notice of Filing of a Proposed 
Rule Change and Amendment No. 1 by Chicago Board Options Exchange, Inc. 
Relating to the Expansion of the Equity Hedge Exemption From Position 
and Exercise Limits

August 10, 2001.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'')\1\ notice is hereby given that on March 31, 2001, the Chicago 
Board Options Exchange, Inc. (``CBOE'' or

[[Page 43275]]

``Exchange'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by the 
Exchange. On July 20, 2001, the CBOE filed Amendment No. 1 with the 
Commission\2\ The Commission is publishing this notice to solicit 
comments on the proposed rule change, as amended, from interested 
persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ Letter from Steve Youhn, Legal Division, CBOE, to Nancy 
Sanow, Assistant Director, Division of Market Regulation 
(``Division''), Commission, dated July 19, 2001 (``Amendment No. 
1''). In response to comments from Commission staff, the Exchange 
submitted Amendment No. 1, which (i) deletes language contained in 
Exchange Rule 4.11 Interpretation .04(b) regarding the limitation on 
the number of contracts that can be maintained under equity hedge 
exemption and (ii) includes examples of the proposed qualified hedge 
strategies.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The CBOE is proposed to expand the current equity hedge exemption 
to eliminate position and exercise limits for certain qualified hedge 
strategies. The current reporting procedures, which serve to identify 
and document hedged positions, would remain in place. The text of the 
proposed rule change is set forth below. Proposed additions are 
italicized and proposed deletions are in brackets.
* * * * *

CHAPTER IV--BUSINESS CONDUCT

Position Limits
    Rule 4.11  No change.
    Interpretations and Polices * * *
    .01-.03  No change.
    .04  Equity Hedge Exemption
    (a) [The following positions, where each option contract is 
``hedged'' by 100 shares of stock or securities convertible into such 
stock, or, in the case of an adjusted option contract, the same number 
of shares represented by the adjusted contract, shall be exempted from 
established position and exercise limits up to that number of option 
contracts, equal to the limit as computed in Interpretation .02 above: 
(I) long call and short stock; (ii) short call and long stock; (iii) 
long put and long stock; and (iv) short put and short stock.] The 
following qualified hedging transactions and positions shall be exempt 
from established position and exercise limits as prescribed under 
Interpretation .02 above:
    (1) Where each option contract is ``hedged; or ``covered'' by 100 
shares of the underlying security or securities convertible into such 
underlying security, or, in the case of an adjusted option contract, 
the same number of shares represented by the adjusted contract; (i) 
long call and short stock; (ii) short call and long stock; (iii) long 
put and long stock; (iv) short put and short stock.
    (2) A long call position accompanied by a short put position, where 
the long call expires with the short put, and the strike price of the 
long call and short put is equal, and where each long call and short 
put position is hedged with 100 shares (or other adjusted number of 
shares) of the underlying security or securities convertible into such 
stock (``reverse conversion'').
    (3) A short call position accompanied by a long put position where 
the short call expires with the long put, and the strike price of the 
short call and long put is equal, and where each short call and long 
put position is hedged with 100 shares (or other adjusted number of 
shares) of the underlying security or securities convertible into such 
stock (``conversion'').
    (4) A short call position accompanied by a long put position, where 
the short call expires with the long put, and the strike price of the 
short call equals or exceeds the long put, and where each short call 
and long put position is hedged with 100 shares of the underlying 
security (or other adjusted number of shares). Neither side of the 
short call, long put position can be in-the-money at the time the 
position is established (``collar'').
    (5) A long call position accompanied by a short put position with 
the same strike price and a short call position accompanied by a long 
put position with a different strike price (``box spread'').
    (6) A listed option position hedged on a one-for-one basis with an 
over-the-counter (``OTC'') option position on the same underlying 
security. The strike price of the listed option position and 
corresponding OTC option position must be within one strike of each 
other and no more than one expiration month apart.
    (7) For those strategies described under (2), (3), and (4) above, 
one component of the option strategy can be an OTC option contract 
guaranteed or endorsed by the firm maintaining the proprietary position 
or carrying the customer account.
    (8) An OTC option contract is defined as an option contract that is 
not listed on a National Securities Exchange or cleared at the Options 
Clearing Corporation.
    (b) The equity hedge exemption is in addition to the standard limit 
and other exemptions available under Exchange rules, interpretation and 
policies. [In no event may the equity hedge exemption for any class of 
stock options exceed twice the standard limit established by Rule 4.11, 
except that the equity hedge exemption for a Market-Maker who also 
receives a market-maker exemption from the standard limit pursuant to 
Interpretation .05 below may not exceed twice the market-maker exempted 
position.]
    .05-.07  No Change.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the CBOE included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The CBOE has prepared summaries, set forth in Sections 
A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The CBOE is proposing to eliminate position and exercise limits 
when certain qualified strategies are employed to establish a hedged 
equity option position.\3\ In May 1988, the Exchange exempted from 
established position and exercise limits four commonly used hedge 
positions: (i) Long call and short stock; (2) short call and long 
stock; (iii) long put and long stock; and (iv) short put and short 
stock.\4\ This equity hedge exemption was in addition to the standard 
limit and other exemptions available under Exchange rules, 
interpretations, and policies. The total aggregate option position held 
by a member or customer account could not exceed two times the standard 
limit. In November 1993, the definition of a hedged position was 
expanded to include securities readily convertible into common 
stock.\5\ In October 1995, the equity hedge exemption was further 
expanded so that the total unhedged

[[Page 43276]]

and hedged option position could not exceed three times the standard 
limit.\6\ Contemporaneous with the expansion of the equity hedge 
exemption, the standard position and exercise limits were also 
expanded, the most recent increase, in December 1998,\7\ increased the 
five-tier position and exercise limit structure to 13,500, 22,500, 
31,500, 60,000 and 75,000 contracts.
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    \3\ The Pacific Exchange, Inc. (``PCX'') has filed a similar 
proposed rule change to eliminate position and exercise limits for 
certain qualified hedge strategies. Securities Exchange Act Release 
No. 44680 (August 10, 2001) (File No. SR-PCX-00-45).
    \4\ Securities Exchange Act Release No. 25738 (May 24, 1988), 53 
FR 20201 (June 2, 1988) (SR-CBOE-87-27).
    \5\ Securities Exchange Act Release No. 33212 (November 17, 
1993), 58 FR 62173 (November 24, 1993) (SR-CBOE-93-52).
    \6\ Securities Exchange Act Release No. 36371 (October 13, 
1995), 60 FR 54269 (October 20, 1995) (SR-CBOE-95-42).
    \7\ Securities Exchange Act Release No. 40875 (December 31, 
1998), 64 FR 1842 (January 12, 1999) (SR-CBOE-98-25).
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    The CBOE believes that since the inception of the equity hedge 
exemption in 1988, the types of hedge strategies employed have become 
more diversified. The Exchange has learned through its experience in 
administering and processing equity hedge exemption information that 
market participants no longer rely solely on a strict stock option 
hedge. While market participants continue to utilize traditional hedge 
strategies such as a covered call or reverse conversion strategy, 
listed option contracts are now utilized to hedge a wider spectrum of 
securities. For example, firms that conduct an over-the-counter 
(``OTC'') options business may use listed options to hedge proprietary 
positions established through the facilitation of customer OTC 
transactions. These market participants maintain that hedging with a 
listed option provides a more realistic hedge because the listed option 
is a mirror image of the OTC option. They also believe that, in some 
instances, hedging with listed options can be more economical than 
hedging with common stock.
    To accommodate more fully the hedging needs of investors, the 
Exchange is proposing to eliminate position and exercise limits when 
certain qualified strategies are employed to establish a hedged equity 
option position. Accordingly, the CBOE proposes to amend Interpretation 
.04 of Exchange Rule 4.11 to expand the definition of a ``qualified'' 
hedged position. Listed below are the proposed qualified hedge 
strategies and their accompanying examples.
    (i) Positions hedged or covered with the underlying security or 
securities readily convertible into stock (long call/short stock or 
short call/long stock or long put/long stock or short put/short stock). 
This hedge strategy is currently exempt pursuant to the equity hedge 
exemption provision contained in Exchange Rule 4.11; contracts are 
covered on a one-for-one basis.
    For example, account ABC is short 5,000 GE Apr 35 calls and long 
500,000 shares of GE common stock. Account ABC is also short 1,000 GE 
April 40 calls but has no corresponding stock hedge. The account is 
exempt on 5,000 contracts hedged with stock and the short 1,000 GE 
April 40 call position is not considered hedged and thus applied to the 
applicable position limit.
    (ii) Reverse Conversion (buy call/sell put (same expiration)/sell 
stock.\8\ For example, assume account ABC establishes the following 
position:
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    \8\ For these strategies one of the option components can be an 
OTC option guaranteed or endorsed by the firm maintaining the 
proprietary position or carrying the customer account. For purposes 
of this rule filing, an OTC option contract is defined as an option 
that is not listed on a National Securities Exchange or cleared at 
the Options Clearing Corporation.

Long 25,000 GE April 35 calls
Short 25,000 GE April 35 puts
Short 2,500,000 shares of GE common stock

    Under the proposed rule change, two options contracts (i.e., one 
long call and one short put) will be treated as one contract for 
hedging purposes. Each reverse conversion option position must be 
hedged with 100 shares of the underlying security to remain exempt. 
Account ABC increases its position by establishing a long call position 
of 5,000 April 40 contracts with no qualified hedge. Option contracts 
held by account ABC number 55,000 on the short call long put side of 
the market. The 50,000 contract reverse conversion position is a 
qualified hedge strategy and is thus exempt from the position and 
exercise limit. The remaining 5,000 contracts and any future position 
established by the account in which a non-qualified strategy is 
employed would be added to the account's existing 5,000 contract 
position and applied to the standard position limit.
    (iii) Conversion (sell call/buy put (same expiration)/buy 
stock).\9\ The components and hedge treatment of the conversion 
strategy is the same as the reverse conversion except that the option 
component of the position is on the short side of the market (i.e., 
short call, long put) and is hedged with long stock.
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    \9\ Id.
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    (iv) Collar (call sell/buy, both out-of-the-money when established 
with the same expiration where the strike price of the short call 
exceeds the strike price of the long pub/buy stock).\10\ A collar 
strategy provides downside protection by the use of put option 
contracts and finances the purchase of the puts through the sale of 
short call options contracts. The goal of this strategy is to bracket 
the price of the underlying security at the time the position is 
established. For example, assume that the price of an underlying 
equity, XYZ, is $53 and account ABC is long 5000 shares of XYZ at $53. 
Account ABC sells 40 XYZ April 55 calls and purchases 50 XYZ April 50 
puts. Under the collar exemption, one collar (i.e., one short call, and 
one long put) must be hedged with 100 shares of the underlying security 
to remain exempt. Additionally, both call and put components of the 
option strategy must be out-of-the-money at the time the position is 
established, both contracts must expire at the same time, and the 
strike price of the short call must exceed the strike price of the long 
position. One leg of the option position (i.e., short call or long put) 
can be an OTC contract guaranteed or endorsed by the firm maintaining 
the proprietary position or carrying the customer account.
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    \10\ Id.
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    (iv) Box Spread (buy call, sell put at one strike price, sell call, 
buy put at another strike price). Assume that account maintaining the 
following position:

Long 5,000 April 35 calls
Short 5,000 April 40 calls
Long 5,000 April 40 puts
Short 5,000 April 35 puts.

    This position is a qualified box spread and would be exempt from 
the position limit. Any future option positions established that do not 
meet the requirements of the qualified hedge strategies would be 
applied to the account's applicable position limit.
    (vi) Listed vs. OTC Options Spreads (options are to generally be 
within the strike of each other and no more than one expiration month 
apart). Member firms that conduct an over-the-counter options business 
utilize the listed options marked to hedge their customer facilitated 
OTC transaction. It is the CBOE's understanding that some member firms 
participate in stock by-back programs whereby the firm purchases OTC 
put option contracts from the subject corporation, the corporation, in 
turn, will be assigned its short put position, thereby ``buying back'' 
its own stock.\11\
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    \11\ The Commission notes that issuers would, of course, need to 
comply with all applicable provisions of the federal securities laws 
in ``buying bacvk'' their own stock.
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    To hedge this position, the firm will sell put option contracts in 
the listed market. For example, Firm ABC purchases 50,000 XYZ puts with 
a strike price of 63.34 expiring in 1/19/03 from XYZ Corporation. At 
the expiration of the OTC contract, the firm will sell to

[[Page 43277]]

XYZ Corporation 5,000,000 shares of its common stock at a price of 
$63.34. To hedge its position, the firm will sell put option contracts 
on the CBOE; often at a strike price close to the noted OTC contract 
with the same expiration date as the OTC contract. OTC contracts hedged 
on a one-for-one basis against listed option contracts would be exempt 
from the position limit. As the OTC position generally does not change, 
Exchange would require the exempt firm to forward to the Exchange, on 
the Monday following the monthly expiration, the status of its OTC 
position.
    Within the list of proposed hedge strategies eligible for an equity 
hedge exemption, the Exchange proposes that the option component of a 
reversal, conversion, or collar position be treated as one contract 
rather than as two contracts. All three strategies serve to hedge a 
related stock portfolio. Because these strategies require the 
contemporaneous \12\ purchase/sale of both a call and put component 
against the appropriate number of shares underlying the option 
(generally 100 shares), the Exchange believes that the position should 
be treated as one contract for hedging purposes.
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    \12\ The Exchange notes that contemporaneous means ``at or about 
the same time.''
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    Under the proposed rule change, the existing standard position and 
exercise limits will remain in place for unhedged equity option 
positions. Once an account nears or reaches the standard limit, 
positions identified as one or more of the proposed qualified hedge 
strategies will be exempted from limit calculations. The exemption will 
be automatic (i.e., does not require pre-approval from the Exchange) to 
the extent that the member identifies that a pre-existing qualified 
hedge strategy is in place or is employed from the point that an 
account's position reaches the standard limit and provides the required 
supporting documentation to the Exchange.
    The exemption will remain in effect to the extent that the exempted 
position remains intact and that the Exchange is provided with any 
required supporting documentation. Procedures to demonstrate that the 
option position remains qualified will be similar to those currently in 
place for equity hedge exemptions. Currently a qualified account must 
report hedge information each time the option position changes. Hedge 
information for member firm and customer accounts are reported to the 
Exchange electronically, via the Large Options Position Report. Market 
maker account information is also reported to the Exchange 
electronically by the member's clearing firm. For those option 
positions that do not change, a filing is generally required on a 
weekly basis. Finally, the existing requirement imposed on member firms 
to report hedge information for proprietary and customer accounts that 
maintain an options position in excess of 10,000 contracts will remain 
in place.
    The CBOE believes that, with the exception of covered stock 
positions, all of the proposed qualified strategies are market 
neutral.\13\ According to the CBOE, none of the proposed strategies 
lend themselves to market manipulation and should therefore be exempt 
from position limits. In addition, the Exchange believes that the 
current reporting requirements under Exchange Rule 4.13, and internal 
surveillance procedures for hedged positions, will enable it to closely 
monitor sizable option positions and corresponding hedges.
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    \13\ According to the Exchange, where covered stock transactions 
are not market neutral (i.e., long stock/short call; short stock/
short put), the market exposure on such activity resides with the 
stock position where no limit is imposed. The CBOE believes that, as 
the short option premium serves to mitigate the stock exposure, no 
limit should be imposed on this strategy.
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2. Statutory Basis
    The Exchange believes that the proposed rule change is consistent 
with Section 6(b) of the Act,\14\ in general, and further the 
objectives of Section 6(b)(5),\15\ in particular, in that it is 
designed to promote just and equitable principles of trade and to 
protect investors and the public interest.
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    \14\ 15 U.S.C. 78f(b).
    \15\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change will 
impose any burden on competition.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants or Others

    No written comments were solicited or received with respect to the 
proposed rule change.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which CBOE consents, the Commission will:
    (A) By order approve such proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change, as amended, is consistent with the Act. The Commission is 
especially interested in receiving written data, views and arguments 
concerning the use of a listed option position hedged on a one-for-one 
basis with an OTC option position on the same underlying security. In 
particular, the Commission staff has concerns that such exemption would 
grant members the ability to sell OTC options and hedge such positions 
on the exchange with listed options on an unlimited basis. This 
potentially raises manipulation concerns. Therefore, the Commission 
staff specifically requests comment on this issue. Persons making 
written submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-0609. 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 in the Commission's Public Reference Section, 450 Fifth Street, 
NW., Washington, DC 20549-0609. Copies of such filing will also be 
available for inspection and copying at the principal office of CBOE. 
All submissions should refer to File Number SR-CBOE-00-12 and should be 
submitted by September 7, 2001.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\16\
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    \16\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-20764 Filed 8-16-01; 8:45 am]
BILLING CODE 8010-01-M