[Federal Register Volume 68, Number 241 (Tuesday, December 16, 2003)]
[Notices]
[Pages 70072-70075]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-30941]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-48875; File No. SR-Phlx-2003-75]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the Philadelphia Stock Exchange, Inc. To Adopt Commentary .04 
of Its Rule 1064 To Allow the Concurrent Representation of Hedging 
Stock Positions With Option Facilitation Orders in the Trading Crowd

December 4, 2003.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on November 17, 2003, the Philadelphia Stock Exchange, Inc. (``Phlx'' 
or ``Exchange'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I, II 
and III below, which Items have been prepared by the Exchange. The 
Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Exchange proposes to adopt Commentary .04 to Phlx Rule 1064, 
Crossing, Facilitation, and Solicited Orders, to allow the concurrent 
representation of hedging stock positions with option facilitation 
orders in the trading crowd (``Stock Tied Up Orders''). The text of the 
proposed rule change is set forth below. Text in italics indicates 
material to be added.
* * * * *
Crossing, Facilitation and Solicited Orders
    Rule 1064. (a)-(c) No change.
    (d) No member organization or person associated with a member or 
member organization who has knowledge of the material terms and 
conditions of a solicited order, an order being facilitated, or orders 
being crossed, the execution of which are imminent, shall enter, based 
on such knowledge, an order to buy or sell an option for the same 
underlying security; an order to buy or sell the security underlying 
such class; or an order to buy or sell any related instrument until (i) 
the terms and conditions of the order and any changes in the terms of 
the order of which the member, member organization or person associated 
with a member or member organization has knowledge are disclosed to the 
trading crowd, or (ii) the trade can no longer reasonably be considered 
imminent in view of the passage of time since the order was received. 
For purposes of this Rule, an order to buy or sell a ``related 
instrument'' means, in reference to an index option, an order to buy or 
sell securities comprising 10% or more of the component securities in 
the index or an order to buy or sell a futures contract on an 
economically equivalent index.
    Commentary:
    .01-.03. No change.
    .04. Rule 1064(d) does not prohibit a member or member organization 
from buying or selling a stock position following receipt of a 
customer's options order but prior to announcing such order to the 
trading crowd, provided that:
    (a) such member or member organization shall create a written 
record that it is engaging in a ``Stock Tied Up Order'' (as described 
below) prior to buying or selling any shares of the underlying stock in 
the hedging stock position;
    (b) such hedging stock position is: (i) comprised of the same 
underlying stock applicable to the option order; (ii) announced 
concurrently with the option order in the crowd; (iii) offered to the 
crowd in its entirety; and (iv) offered, at the stock execution price 
received by the member organization introducing the order, to any 
option crowd participant who has established parity or priority for the 
related options;
    (c) the hedging stock position does not exceed the options order on 
a delta basis; and
    (d) the hedging stock order is transacted promptly upon receipt of 
the

[[Page 70073]]

option order and, if brought to the Exchange, is brought without undue 
delay to the crowd. Crowd participants may participate in the option 
transaction without participating in the hedging stock position. 
Combination option and stock positions offered in reliance upon this 
Commentary .04 shall be referred to as ``Stock Tied Up Orders.''
* * * * *

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 Exchange 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 Exchange 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 Phlx represents that the purpose of the proposed rule change is 
to expressly adopt into Exchange rules concerning the handling of 
certain option orders, Stock Tied Up Orders, to bring clarity to the 
practice of representing hedging stock positions in conjunction with 
option orders in the trading crowd.
    In a Stock Tied Up Order, Exchange members would be permitted to 
hedge a customer options order with the underlying security, and then 
forward the customer order and hedging stock position to a Floor Broker 
with instructions to represent the customer order together with the 
hedging stock position in the underlying security to the options crowd. 
Under the proposal, the trading crowd would have the choice to 
participate in the option portion of the transaction or both the option 
and stock hedging position.
    The proposal would also include a number of conditions which must 
be satisfied both prior to the time a Stock Tied Up Order is 
represented to the options trading crowd, and concurrently with the 
representation of a Stock Tied Up Order in the trading crowd.
    Currently, Exchange market participants trading options employ a 
number of strategies that involve multiple securities, including non-
option components. For example, Exchange Rule 1066 permits Exchange 
members to engage in the trading of spread \3\ and combination \4\ 
orders, as well as synthetic options.\5\ The Stock Tied Up Order would 
also include an option component and a stock component.
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    \3\ A spread order is an order to buy a stated number of option 
contracts and to sell the same number of option contracts, in a 
different series of the same class of options. In the case of 
adjusted stock option contracts, a spread order need not consist of 
the same number of put and call contracts if such contracts both 
represent the same number of underlying shares or foreign currency 
at option, in a different series of the same class of options. See 
Exchange Rule 1066(f)(1).
    \4\ A combination order is an order involving a number of call 
option contracts and the same number of put option contracts in the 
same underlying security and representing the same number of shares 
at option (if the underlying security is a stock or Exchange-Traded 
Fund Share) or the same number of foreign currency units (if the 
underlying security is a foreign currency). A combination order 
includes a conversion (generally, buying a put, selling a call, and 
buying the underlying stock or Exchange-Traded Fund Share) and a 
reversal (generally, selling a put, buying a call, and selling the 
underlying stock or Exchange-Traded Fund Share). In the case of 
adjusted option contracts, a combination order need not consist of 
the same number of shares at option. See Exchange Rule 1066(f)(3).
    \5\ A synthetic option order is an order to buy or sell a stated 
number of option contracts and buy or sell the underlying stock or 
Exchange-Traded Fund Share in an amount that would offset (on a one-
for-one basis) the option position. For example:
    (i) Buy-write: An example of a buy-write is an order to sell one 
call and buy 100 shares of the underlying stock or Exchange-Traded 
Fund Share.
    (ii) Synthetic put: An example of a synthetic put is an order to 
buy one call and sell 100 shares of the underlying stock or 
Exchange-Traded Fund Share.
    (iii) Synthetic call: An example of a synthetic call is an order 
to buy (or sell) one put and buy (or sell) 100 shares of the 
underlying stock or Exchange-Traded Fund Share. See Exchange Rule 
1066(g).
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    The proposed rule would require members and member organizations to 
satisfy certain conditions prior to representing Stock Tied Up Orders 
in the crowd. First, members or member organizations would be required 
to create a written record that it is engaging in a Stock Tied Up Order 
prior to buying or selling any shares of the underlying stock in the 
hedging stock position. The Exchange states that the purpose of this 
provision is to create a record to ensure that stock trades would be 
appropriately associated with the related options order. The Exchange 
believes that this requirement should enable the Exchange to surveil 
for compliance with the requirements of proposed Commentary .04(b) of 
Phlx Rule 1064, as discussed below, by identifying the specific 
purchase or sell orders relating to the hedging stock position.
    Secondly, proposed Commentary .04(b) of Phlx Rule 1064 would 
require that members and member organizations that have decided to 
engage in Stock Tied Up Orders for representation in the trading crowd 
would have to ensure that the hedging stock position associated with 
the Stock Tied Up Order is comprised of the same underlying stock 
applicable to the option order. For example, if the option component of 
the Stock Tied Up Order overlies XYZ stock, then the hedging stock 
position associated with the order would have to be XYZ stock. The 
Exchange states that the purpose of this provision is to ensure that 
the hedging stock position would be for the same stock as the overlying 
option, thus allowing crowd participants who may be considering 
participation in a Stock Tied Up Order to adequately evaluate the risk 
associated with the option as it relates to the actual underlying 
stock. Occasionally, crowd participants hedge option positions with 
stock that is related to the option, such as the stock of an issuer in 
the same industry, but not the actual stock associated with the option. 
The proposed rule change would not allow such a ``related'' hedging 
stock position, but would require the hedging stock position to be the 
actual security underlying the option.
    The proposal would require that the hedging stock position be 
announced concurrently with the option order in the crowd, offered to 
the crowd in its entirety, and offered at the stock execution price 
received by the member organization introducing the order to any option 
crowd participant who has established parity or priority for the 
related options. The Phlx states that the purpose of these requirements 
is to ensure that the hedging stock position represented to the crowd 
would be a good faith effort to provide crowd participants with the 
same opportunity as the member or member organization introducing the 
Stock Tied Up Order to compete for the option order. For example, if 
the member or member organization introducing the Stock Tied Up Order 
were to offer 1,000 XYZ option contracts to the crowd (overlying 
100,000 shares of XYZ stock) and concurrently offers only 30,000 shares 
of the underlying stock, crowd participants might only be willing or 
able to participate in 300 of the option contracts offered, if the 
hedging stock position cannot be obtained at a price as favorable as 
the stock hedging position offering price, if at all. The Exchange 
states that the effect of this would be to place the crowd at a 
disadvantage relative to the introducing member firm for the remaining 
700 option contracts

[[Page 70074]]

in the Stock Tied Up Order, and thus create a disincentive for the 
crowd to bid or offer competitively for the remaining 700 option 
contracts. The Exchange believes that the requirement to present the 
hedging stock position concurrently with the option order in the crowd 
and offered to the crowd in its entirety at the stock execution price 
received by the member organization introducing the order should ensure 
that the crowd would be competing on a level playing field with the 
introducing member or member organization to provide the best price to 
the customer.
    In addition, the proposal would require that the hedging stock 
position not exceed the options order on a delta basis.\6\ For example, 
in the situation where a Stock Tied Up Order involves the simultaneous 
purchase of 100 shares of XYZ stock and the sale of 1 XYZ call contract 
(known as a ``buy-write''), and the delta of the option is 100, it 
would be considered ``hedged'' by 100 shares of stock. Accordingly, the 
proposed rule would not allow the introducing member firm to purchase 
more than 100 shares of stock in the hedging stock position. The 
Exchange believes that it is reasonable to require that the hedging 
stock position be in amounts equivalent to the size of the related 
options order on a delta basis, and not for a greater number of shares 
of stock. The Exchange believes that the proposed rule change would 
support its view that the member or member organization introducing the 
Stock Tied Up Order be guided by the notion that any excess hedging 
activity could be detrimental to the eventual execution price of the 
customer order. Consequently, while delta estimates may vary slightly, 
the introducing member or member organization would be required to 
assume hedging stock positions not to exceed the equivalent size of the 
options order on a delta basis.
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    \6\ The price of an option is not completely dependent on supply 
and demand, nor on the price of the underlying security. Specialists 
and ROTs price options based on basic measures of risk as well. One 
of these such measures, delta, is the rate of change in the price of 
an option as it relates to changes in the price of the underlying 
security. The delta of an option is measured incrementally based on 
movement in the price of the underlying security. For example, if 
the price of an option increases or decreases by $1.00 for each 
$1.00 increase or decrease in the price of the underlying security, 
the option would have a delta of 100. If the price of an option 
increases or decreases by $.50 for each $1.00 increase or decrease 
in the price of the underlying security, the option would have a 
delta of 50. See, e.g., Securities Exchange Act Release No. 45575 
(March 15, 2002), 67 FR 13395 (March 22, 2002) (SR-Phlx-2001-25).
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    The proposed rule change would also require that the hedging stock 
order be transacted by the member or member organization introducing 
the Stock Tied Up Order promptly upon receipt of the option order, and, 
if brought to the Exchange, such order would be required to be brought 
without undue delay to the crowd. The Exchange believes that in many 
circumstances the member or member organization introducing the Stock 
Tied Up Order would best serve the interest of the customer by 
establishing the hedging stock position over a brief period of time, 
rather than by way of a block-sized market order that could be of high-
impact to the stock price. However, the Exchange states that the 
``prompt'' requirement of the proposed rule is intended to ensure that 
this working period be brief so that the hedging stock position could 
be brought to the Floor under optimal circumstances for crowd 
participants to compete most effectively. To accomplish this, the 
Exchange believes that the hedging stock position must be reasonably 
related to the price of the option order upon receipt of the option 
order. In the event a delay does occur and the stock price becomes 
unattractive as a hedge, the proposed rule would provide that the crowd 
participants could elect to participate in the option order without 
participating in the hedging stock position.
    Finally, while the particular circumstances surrounding each 
transaction on the Exchange's options floor are different, the Exchange 
does not believe, as a general proposition, that the Stock Tied Up 
Order would be inherently harmful or detrimental to customers. The fact 
that the parties to such a trade end up fully hedged may contribute to 
the best execution of the orders, and, in any event, participants 
continue to be governed by, among other things, their best execution 
responsibilities.
2. Statutory Basis
    The Exchange believes that the proposed rule change is consistent 
with Section 6(b) of the Act \7\ in general, and furthers the 
objectives of Section 6(b)(5) of the Act \8\ in particular, because it 
is designed to promote just and equitable principles of trade, to 
foster cooperation and coordination with persons engaged in regulating, 
clearing, settling, processing information with respect to, and 
facilitating transactions in securities, to remove impediments to and 
perfect the mechanism of a free and open market and a national market 
system, and, in general, to protect investors and the public interest, 
by establishing rules governing Stock Tied Up Orders, which include 
specific requirements and procedures to be followed prior to and during 
representation of such orders in the crowd.
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    \7\ 15 U.S.C. 78f(b).
    \8\ 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 inappropriate 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.

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 the Exchange 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. In particular, the Commission seeks 
commenters' specific views on whether the proposed rule change is 
consistent with the Act. What would be the impact under the proposed 
rule change of allowing Phlx members to hedge large options orders 
while avoiding pressures on the market for the underlying securities 
that can result from the reporting of such options transactions to the 
tape? Would the proposed rule change violate prohibitions on front 
running? Should the proposed rule change provide specific standards to 
determine when a member's hedging stock position does not exceed the 
options order on a delta basis?
    Persons making written submissions should file six copies thereof 
with the Secretary, Securities and Exchange Commission, 450 Fifth 
Street, NW., Washington, DC 20549-0609. Comments may also be submitted 
electronically at the following e-mail address: [email protected]. 
All comment letters should refer to File No. SR-Phlx-2003-75. This file 
number

[[Page 70075]]

should be included on the subject line if e-mail is used. To help us 
process and review comments more efficiently, comments should be sent 
in hardcopy or by e-mail but not by both methods. 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 Phlx.
    All submissions should refer to file number SR-Phlx-2003-75 and 
should be submitted by January 6, 2004.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\9\
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    \9\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-30941 Filed 12-15-03; 8:45 am]
BILLING CODE 8010-01-P