[Federal Register Volume 67, Number 59 (Wednesday, March 27, 2002)]
[Notices]
[Pages 14751-14753]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-7327]



[[Page 14751]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45603; File No. SR-CBOE-00-12]


Self Regulatory Organizations; Chicago Board Options Exchange, 
Inc.; Order Approving Proposed Rule Change and Notice of Filing and 
Order Granting Accelerated Approval to Amendment No. 2 to the Proposed 
Rule Change Relating to the Expansion of the Equity Hedge Exemption 
From Position and Exercise Limits

March 20, 2002.

I. Introduction

    On March 31, 2001, the Chicago Board Options Exchange, Inc. 
(``CBOE'' or ``Exchange'') filed with the Securities 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 expand the current equity 
hedge exemption to eliminate position and exercise limits for certain 
qualified hedge strategies.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    On July 20, 2001, the CBOE filed Amendment No. 1 with the 
Commission.\3\ The proposed rule change and Amendment No. 1 thereto 
were published for comment in the Federal Register on August 17, 
2001.\4\ On February 22, 2002, the CBOE submitted Amendment No. 2 to 
the proposal.\5\ The Commission received no comments on the proposal.
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    \3\ See 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 the equity 
hedge exemption and (ii) includes examples of the proposed qualified 
hedge strategies.
    \4\ See Securities Exchange Act Release No. 44681 (August 10, 
2001), 66 FR 43274.
    \5\ See Letter from Christopher R. Hill, CBOE, to Nancy Sanow, 
Assistant Director, Division, Commission, dated February 21, 2001 
(``Amendment No. 2''). In Amendment No. 2, the CBOE established a 
position and exercise limit equal to no greater than five times the 
standard limit for those hedge strategies that include an OTC option 
component.
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II. Description of the Proposal

    The Exchange is proposing to eliminate position and exercise limits 
when certain qualified strategies are employed to establish a hedged 
equity option position and to establish a position and exercise limit 
of five times the standard limit for those strategies that include an 
OTC option contract. 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).\6\ For example, assume account ABC establishes the following 
position:

    \6\ 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. Hedge 
transactions and positions established pursuant to these strategies 
are subject to a position limit equal to five times the standards 
limit established under CBOE Rule 4.11, Interpretation .02. 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.
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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 positions 
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).\7\ 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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    \7\ Id.
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    (iv) Collar (sell call/buy put, 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 put/buy stock).\8\ 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 option 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 50 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 
put 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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    \8\ Id.
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    (v) Box Spread (buy call, sell put at one strike price, sell call, 
buy put at another strike price). Assume that account ABC maintains 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 generally to be 
within one strike of each other and no more than

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one expiration month apart).\9\ Member firms that conduct an over-the-
counter options business utilize the listed options market to hedge 
their customer facilitated OTC transactions. It is the CBOE's 
understanding that some member firms participate in stock buy-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.
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    \9\ Hedge transactions and positions established pursuant to 
this strategy are subject to a position limit equal to five times 
the standards limit established under CBOE Rule 4.11, Interpretation 
.02.
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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 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, the 
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 \10\ 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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    \10\ 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.

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 exchange \11\ and, in 
particular, the requirements of section 6 of the Act \12\ and the rules 
and regulations thereunder. The Commission finds specifically that the 
proposed rule change is consistent with section 6(b)(5) of the Act \13\ 
in that it is designed to promote just and equitable principles of 
trade, to foster cooperation and coordination with persons engaged in 
facilitating transactions in securities, and to remove impediments to 
and perfect the mechanism of a free and open market and a national 
market system.
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    \11\ In approving this proposed rule change, the Commission 
notes that it has considered the proposed rule's impact on 
efficiency, competition, and capital formation. 15 U.S.C. 78c(f).
    \12\ 15 U.S.C. 78f.
    \13\ 15 U.S.C. 78f(b)(5).
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    Position and exercise limits serve as a regulatory tool designed to 
address potential manipulative schemes and adverse market impact 
surrounding the use of options. In general, the Commission has taken a 
gradual, evolutionary approach toward expansion of position and 
exercise limits. The Commission has been careful to balance two 
competing concerns when considering the appropriate level at which to 
set position and exercise limits. The Commission has recognized that 
the limits must be sufficient to prevent investors from disrupting the 
market in the component securities comprising the indexes. At the same 
time, the Commission has determined that limits must not be established 
at levels that are so low as to discourage participation in the options 
market by institutions and other investors with substantial hedging 
needs or to prevent specialists and market makers from adequately 
meeting their obligations to maintain a fair and orderly market.\14\
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    \14\ Id.
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    The Commission has carefully considered the CBOE's proposal to 
expand the hedge exemption from position and exercise limits. Given the 
market neutral characteristic of all the proposed qualified hedge 
strategies (except covered stock positions), the Commission believes it 
is permissible to expand the current equity hedge exemption without 
risk of disruption to the options or underlying cash markets. 
Specifically, the Commission believes that existing position and 
exercise limits, procedures for maintaining the exemption, and the 
reporting requirements imposed by the Exchange will help protect 
against potential manipulation. The Commission notes that the existing 
standard position and exercise limits will remain in place for unhedged 
equity option positions. To further ensure against market disruption, 
the CBOE will establish a position and exercise limit equal to no 
greater than five times the standard limit for those hedge strategies 
that include an OTC option component.
    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. Although the exemption will 
be automatic (i.e., does not require pre-approval from the Exchange), 
the exemption will remain in effect only to the extent that the 
exempted position remains intact and that the Exchange is provided with 
any required supporting documentation.
    In addition, as described above, 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

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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 Commission believes these reporting requirements will help the 
CBOE to monitor options positions and ensure that only qualified hedges 
are being exempt from position and exercise limits. To the extent that 
any position raises concerns, the Commission believes that the CBOE, 
through its monitoring, will be promptly notified, and the Commission 
would expect the CBOE to take any appropriate action, as permitted by 
its rules.
    The Commission finds good cause, pursuant to section 19(b)(2) of 
the Act,\15\ for approving Amendment No 2 to the proposal prior to the 
thirtieth day after the date of publication of notice of filing thereof 
in the Federal Register. Amendment No. 2 establishes a position and 
exercise limit equal to no greater than five times the standard limit 
for those hedge strategies that include an OTC option component. 
Setting the position and exercise limit at this level should provide 
Exchange members greater flexibility in using hedge strategies 
advantageously, while providing an adequate level of protection against 
the opportunity for manipulation of these securities and disruption in 
the underlying market. Accordingly, the Commission finds good cause, 
consistent with sections 6(b)(5) \16\ and 19(b)(2) \17\ of the Act to 
accelerate approval of Amendment No. 2 to the proposed rule change.
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    \15\ 15 U.S.C. 78s(b)(2).
    \16\ 15 U.S.C. 78f(b)(5).
    \17\ 15 U.S.C. 78s(b)(2).
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 2, including whether it is 
consistent with the Act. 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 Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the CBOE. All 
submissions should refer to File No. SR-CBOE-00-12 and should be 
submitted by April 17, 2002.

V. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\18\ that the proposed rule change (File No. SR-CBOE-00-12), as 
amended, be and hereby is, approved.
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    \18\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\19\
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    \19\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-7327 Filed 3-26-02; 8:45 am]
BILLING CODE 8010-01-P