Self-Regulatory Organizations; Order Granting Approval to Proposed Rule Change and Notice of Filing and Order Granting Accelerated Approval to Amendment No. 1 to Proposed Rule Change by the Chicago Board Options Exchange, Inc., To Add Two Position and Exercise Limit Tiers for Qualifying Equity Option Classes and To Expand the Equity Option Hedge Exemption

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-36371; File No. SR-CBOE-95-42]

Self-Regulatory Organizations; Order Granting Approval to

Proposed Rule Change and Notice of Filing and Order Granting

Accelerated Approval to Amendment No. 1 to Proposed Rule Change by the

Chicago Board Options Exchange, Inc., To Add Two Position and Exercise

Limit Tiers for Qualifying Equity Option Classes and To Expand the

Equity Option Hedge Exemption

October 13, 1995.

I. Introduction

On August 7, 1995, the Chicago Board Options Exchange, Inc.

(``CBOE'' or ``Exchange'') submitted to 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 amend Rule 4.11 (Position

Limits) and Rule 4.12 (Exercise Limits) to add two upper position and

exercise limit \3\ tiers for those equity option classes that meet

certain criteria for high liquidity in the underlying stocks. In

addition, the CBOE proposed to expand its current equity option hedge

exemption from twice to three times the standard or base position

limit.\4\

\1\ 15 U.S.C. Sec. 78s(b)(1) (1988).

\2\ 17 CFR 240.19b-4 (1994).

\3\ Position limits impose a ceiling on the aggregate number of

option contracts on the same side of the market that an investor, or

group of investors acting in concert, may hold or write. Similarly,

exercise limits impose a ceiling on the aggregate long positions in

option contracts that an investor, or group of investors acting in

concert, can or will have exercised within five consecutive business

days.

\4\ The equity hedge exemption currently exempts certain

specified equity options positions from the stated (or base)

position limits in Exchange Rule 4.11 where the option contracts are

hedged by 100 shares of stock or securities convertible into such

stock (or hedged by the same number of shares represented by an

adjusted option contract), up to a maximum allowable position of

twice the standard or base limit.

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Notice of the proposed rule change appeared in the Federal Register

on

[[Page 54270]]

August 28, 1995.\5\ Two comment letters were received in response to

the proposal.\6\ The Exchange subsequently filed Amendment No. 1 to the

proposed rule change on October 2, 1995.\7\

\5\ See Securities Exchange Act Release No. 36124 (August 18,

1995), 60 FR 44524 (August 28, 1995).

\6\ See Letter from CS First Boston, Goldman, Sachs & Co., J.P.

Morgan Securities, Lehman Brothers, Merrill Lynch & Co., Morgan

Stanley & Co., PaineWebber Incorporated, and Salomon Brothers Inc.,

to Jonathan G. Katz, Secretary, Commission, dated September 18, 1995

(``Working Group Letter''); and letter from Peter A. Ianello,

President, and Patricia Levy, Executive Director, Swiss Bank

Corporation Capital Markets, Inc., to Jonathan G. Katz, Secretary,

Commission, dated September 28, 1995 (supporting views expressed in

Working Group Letter).

\7\ In Amendment No. 1, the CBOE stated its intention to

restrict the use of the new position and exercise limit tiers and

the expanded hedge exemption to option classes which solely trade on

the Exchange and are not multiply traded. Implementation of the

proposed rule change for multiply traded option classes will be

delayed until the Commission approves similar proposals by the other

options exchanges or the Commission otherwise determines that

implementation is appropriate. See letter from Mary L. Bender,

Senior Vice President, Division of Regulatory Services, CBOE, to

Holly Smith, Associate Director, Division of Market Regulation

(``Division''), Office of Market Supervision (``OMS''), Commission,

dated October 2, 1995 (``Amendment No. 1'').

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II. Background and Description

Since the inception of standardized options trading, the options

exchanges have had rules imposing limits on the aggregate number of

options contracts that a member or customer could hold or exercise.

These rules are intended to prevent the establishment of large options

positions that can be used or might create incentives to manipulate or

disrupt the underlying market so as to benefit the options position. In

particular, position and exercise limits are designed to minimize the

potential for mini-manipulations \8\ and for corners or squeezes of the

underlying market. In addition, they serve to reduce the possibility

for disruption of the options market itself, especially in illiquid

options classes.

\8\ Mini-manipulation is an attempt to influence, over a

relatively small range, the price movement in a stock to benefit a

previously established derivatives position.

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In establishing position and exercise limits, the Commission has

been careful to balance two competing concerns. First, the Commission

has recognized that the limits must be sufficient to prevent investors

from disrupting the market for the underlying security by acquiring and

exercising a number of options contracts disproportionate to the

deliverable supply and average trading volume of the underlying

security. At the same time, the Commission has realized 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.\9\

\9\ See H.R. Rept. No. IFC-3, 96th Cong., 1st Sess. at 189-91

(Comm. Print 1978) (``Options Study'').

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In October 1980, the Commission approved proposed rule changes by

the options exchanges to increase position and exercise limits from

1,000 to 2,000 contracts for all individual equity options classes.\10\

In conjunction with the approval, the Commission received commitments

from the options exchanges to study the effects of the increased

limits. The Commission indicated that the experience gained under the

increased limits, if coupled with adequate monitoring and surveillance

procedures, could serve as a basis for considering further position and

exercise limit modifications.

\10\ See Securities Exchange Act Release No. 17237 (October 22,

1980), 45 FR 71454 (October 28, 1980) (``1980 Release'').

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In July 1983, the Commission approved a further increase in

position and exercise limits for individual stock options based on a

tiering approach.\11\ Limits for options on stocks with the greatest

trading volume and public float were increased to 4,000 contracts and

limits on all other options classes were increased to 2,500

contracts.\12\ In approving the increased limits under a two-tiered

framework, the Commission noted that tiering was consistent with the

gradual, evolutionary approach that the Commission and the exchanges

have adopted in increasing position and exercise limits.

\11\ See Securities Exchange Act Release No. 19975 (July 15,

1983), 48 FR 33389 (July 21, 1983) (``1983 Release'').

\12\ To be eligible for the 4,000 contract limit an underlying

security was required to have had either (i) trading volume of at

least 20 million shares during the most recent six month trading

period; or (ii) trading volume of at least 15 million shares during

the most recent six month trading period and at least 60 million

shares currently outstanding. All other options not meeting these

requirements were subject to the 2,500 contract limits.

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In 1985, the Commission approved a further increase in position and

exercise limits for individual equity options. This approval extended

the tiering approach commenced by the options exchanges in 1983.\13\

The Commission noted in the 1985 Release that liberalizing position and

exercise limits would further increase the potential depth and

liquidity of the individual stock options markets without significantly

increasing concerns regarding intermarket manipulations or disruptions

of the market for the options or underlying securities.

\13\ See Securities Exchange Act Release No. 21907 (March 29,

1985), 50 FR 13440 (April 4, 1985) (``1985 Release''). The 1985

Release created a three-tiered system of position and exercise

limits of 8,000, 5,500, and 3,000 contracts. To be eligible for the

8,000 contract limit an underlying security was required to have had

either (i) trading volume of at least 40 million shares during the

most recent six month trading period; or (ii) trading volume of at

least 30 million shares during the most recent six month trading

period and at least 120 million shares currently outstanding. To be

eligible for the 5,500 contract limit an underlying security was

required to have had either (ii) trading volume of at least 20

million shares during the most recent six month trading period; or

(ii) trading volume of at least 15 million shares during the most

recent six month trading period and at least 40 million shares

currently outstanding. All other options not meeting these

requirements were subject to the 3,000 contract limits.

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Lastly, in December 1993, the Commission approved the CBOE's

existing position and exercise limit framework for individual equity

options.\14\ Depending on certain criteria related to the trading

volume of the underlying stock or a combination of both the trading

volume and the number of shares outstanding of the underlying stock,

the Exchange's current position and exercise limits were established at

levels of 10,500 contracts, 7,500 contracts, and 4,500 contracts.\15\

\14\ See Securities Exchange Act Release No. 33283 (December 3,

1993), 58 FR 65204 (December 13, 1993) (``1993 Release'').

\15\ To be eligible for the 10,500 contract limit an underlying

security must have either (i) trading volume of at least 40 million

shares during the most recent six month trading period; or (ii)

trading volume of at least 30 million shares during the most recent

six month trading period and at least 120 million shares currently

outstanding. To be eligible for the 7,500 contract limit an

underlying security must have either (i) trading volume of at least

20 million shares during the most recent six month trading period;

or (ii) trading volume of at least 15 million shares during the most

recent six month trading period and at least 40 million shares

currently outstanding. All other options not meeting these

requirements are subject to the 4,500 contract limits.

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The Exchange proposes to add two position and exercise limit tiers

at 25,000 and 20,000 contract levels. The criterion to qualify for the

proposed 25,000 contract limit will require that the underlying

security must have at least 300 million shares outstanding with 75

million shares traded in the past six months, or have 100 million

shares traded in the past six months. To qualify for the proposed

20,000 contract limit, the underlying security must have at least 240

million shares outstanding with 60 million shares traded in the past

six months, or have 80 million shares traded in the past six months.

According to the Exchange, the number of equity option classes

currently listed on the CBOE that would qualify for either of these new

higher position and exercise limit tiers is small. The Exchange

represents that based on

[[Page 54271]]

available statistics, as of June 30, 1995, approximately 73 classes

would qualify for the 25,000 contract tier. Similarly, approximately 22

classes would satisfy the requirements for the 20,000 contract tier,

out of approximately 580 equity option classes currently listed on the

CBOE.

In addition to the proposed 25,000 and 20,000 contract tiers, the

CBOE is also proposing to expand the equity hedge exemption in Rule

4.11, Interpretation and Policy .04. Under this proposal, the maximum

allowable position, after exempting from the base limit specified

positions where the option contract is hedged by 100 shares of stock or

securities convertible into stock, will be three times instead of twice

the standard or base limit currently provided.\16\

\16\ The Commission notes that the proposed increase in the

maximum hedge exemption will apply to all position limit tiers, not

just to the proposed 25,000 and 20,000 contract tiers.

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As set forth in greater detail in a recent report prepared by the

Exchange (``Study''),\17\ the CBOE has represented that position and

exercise limit tiers can be added and that the equity hedge exemption

can be expanded to the benefit of investors without increasing the

potential for market disruption.\18\

\17\ See Letter from Mary Bender, Senior Vice President,

Division of Regulatory Services, CBOE, to Holly Smith, Associate

Director, OMS, Division, Commission, dated April 28, 1995 (market

analysis of increased limits and expanded hedge exemption).

\18\ See Securities Exchange Act Release No. 36124 (August 18,

1995), 60 FR 44524 (August 28, 1995) (notice of File No. SR-CBOE-95-

42) (summarizing findings of Study).

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III. Summary of Comments

The Commission received two comment letters on the proposed rule

change.\19\ The commenters, in general, expressed support for the

proposed changes noting that there is a demonstrated need for the

higher tiers and that the higher tiers and expanded hedge exemption

will not increase market disruptions. Although believing that the

proposals are a ``good first step'' in reducing the undue constraints

imposed by position limits, the commenters state that further expansion

of position limits is required. Specifically, the commenters note that

the depth and liquidity of the markets for many of the most highly

capitalized and actively traded stocks support the allowance of large

options positions and that increased levels will not raise concerns

about manipulation or disruption of the market for the underlying

stock. Moreover, the commenters state that due to the sophisticated

surveillance systems currently in place in the markets, any efforts to

manipulate the market with large positions in options would be readily

detectable. In this light, the commenters believe that further

increases in tier size are warranted.

\19\ See supra note 6.

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In addition, the commenters stated that any limitation on the

ability of market participants to use options to hedge their positions

exposes participants to unnecessary risk on the unhedged portion of

their portfolios. In this regard, the commenters believe that the

adoption of an uncapped hedge exemption (i.e., the ability to

accumulate an unlimited number of options contracts provided that such

contracts are properly hedged) is appropriate.\20\

\20\ The Commission notes that prior to the CBOE submitting its

proposed rule change, the Exchange received six letters from member

firms supporting an increase in the current position limit levels.

Further, the CBOE received comments from member firm representatives

and customers who stated that they did not have adequate hedging

capabilities under the current position limit tiers. Lastly, the

CBOE received comment from money managers who believed that the

current equity option position limits were too restrictive with

respect to the size of assets managed.

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IV. Discussion

The Commission finds that the proposed rule changes are consistent

with the requirements of the Act and the rules and regulations

thereunder applicable to a national securities exchange, and, in

particular, with the requirements of Section 6(b)(5).\21\ Specifically,

the Commission believes that the proposed addition of position and

exercise limit tiers of 25,000 contracts and 20,000 contracts for

qualifying equity options, and the proposed expansion of the equity

hedge exemption to three times the standards or base limit will

accommodate the needs of investors and market participants. The

Commission also believes that the proposed rule changes will increase

the potential depth and liquidity of the equity options market as well

as the underlying cash market without significantly increasing concerns

regarding intermarket manipulations or disruptions of the market for

the options or underlying securities. Accordingly, as discussed below,

the rule proposal is consistent with the requirements of Section

6(b)(5) that Exchange rules facilitate transactions in securities while

continuing to further investor protection and the public interest.

\21\ 15 U.S.C. 78f(b)(5) (1988).

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In approving the increased limits, the Commission recognizes that

securities with active and deep trading markets, as well as with broad

public ownership, are more difficult to manipulate or disrupt than

securities having less active and deep markets and having smaller

public floats.\22\ The proposed additional position and exercise limit

tiers recognize this by seeking to minimize the restraints on those

options classes that can accommodate larger limits without

significantly increasing manipulation concerns.\23\ In particular, the

proposed limit of 25,000 contracts and 20,000 contracts for options on

the most actively traded, widely held securities, permits the

Commission to avoid placing unnecessary restraints on those options

where the manipulative potential is the least and the need for

increased positions likely is the greatest. Accordingly, the Commission

believes that the additional position and exercise limit tiers and the

expanded equity hedge exemption is warranted.

\22\ The Commission notes that the quantitative options listing

and maintenance standards require: (1) A minimum of 7 and 6.3

million shares outstanding, respectively, which are owned by persons

other than ``insiders,'' as defined in Section 16 of the Act; (2) a

minimum of 2,000 and 1,600 shareholders, respectively; (3) trading

volume of at least 2.4 and 1.8 million shares, respectively, during

the past twelve months; (4) for an original listing, the market

price per share of the underlying security must have closed at or

above $7.50 during the majority of business days over the preceding

three months; and (5) to maintain its listing, the market price per

share of the underlying security must have closed at or above $5

during the majority of business days over the preceding six months.

See CBOE Rule 5.4, Interpretation and Policy .01.

\23\ The Commission continues to believe that proposals to

increase position and exercise limits must be justified and

evaluated separately. After reviewing the proposed exercise limits,

along with the eligibility criteria for the two new tiers, the

Commission has concluded that the proposed exercise limit additions

do not raise manipulation problems or increase concerns over market

disruption in the underlying securities.

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The Commission believes that the proposed additions to the CBOE's

position and exercise limit tiers and increased hedge exemption appear

to be both appropriate and consistent with the Commission's gradual,

evolutionary approach. There are no ideal limits in the sense that

options positions of any given size can be stated conclusively to be

free of any manipulative concerns. The Commission, however, is relying

on the absence of discernible manipulation problems under the current

framework as an indicator that the proposed additional limit tiers and

expanded hedge exemption is justified.

The Commission does not believe that the addition of the two new

higher limit tiers and the expanded hedge exemption will have any

adverse effects on the options markets. In approving the two-tiered

system in 1983, the Commission stated that it did not believe that

requiring traders to keep track of two

[[Page 54272]]

limits rather than one was burdensome or confusing or would lead to

accidental violations.\24\ The Commission does not believe that a

change from the current three tiers to five tiers should change this

conclusion. Similarly, as the Commission views the expansion of the

equity hedge exemption as consistent with its steady progression in

this area, the enactment of the proposed rule change should not prove

difficult to implement or cumbersome to monitor.

\24\ In this regard, the Commission notes that the CBOE

routinely, and on a continuous basis, reviews the trading

characteristics of the underlying stocks to determine the

appropriate position and exercise limit tiers for the option

classes.

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The Commission believes that although position and exercise limits

for options must be sufficient to protect the options and related

markets from disruptions by manipulations, the 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 market makers from adequately meeting their

obligations to maintain a fair and orderly market. In this regard, the

CBOE has noted that customers and member firms view the current

position and exercise limits for certain options classes as too low.

The Commission believes that the CBOE's proposal is a reasonable and

appropriately tailored effort to accommodate the identified needs of

options market participants.\25\ In this regard it is important to note

that the proposal only adds higher position and exercise limit tiers

for classes of options overlying the most liquid stocks. As a result,

the proposal currently affects only 95 of the existing 580 classes of

equity options that are traded on the CBOE.

\25\ See Study, supra note 17, at 3, and Comment Letters, supra

note 6.

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In 1988, the Commission approved a pilot program proposed by the

CBOE which provided exemptions from position limits for certain fully

hedged equity option positions.\26\ The pilot program created an

exemption from equity option position and exercise limits for accounts

that had established one of the four most commonly used hedged

positions.\27\ Under this exemption, the maximum position limit

(including the allowable exemptions) could not exceed twice the

established option position limit.\28\

\26\ See Securities Exchange Act Release No. 25738 (May 24,

1988), 53 FR 20201 (June 2, 1988) (``Pilot Approval Order'').

\27\ The four hedged positions are: (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.

\28\ In May 1995, after several extensions, the Commission

granted permanent approval to the CBOE's hedge exemption pilot

program. See Securities Exchange Release No. 35738 (May 18, 1995),

60 FR 27573 (May 24, 1995).

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The Exchange currently proposes to increase the hedge exemption to

three times the applicable position limits. According to the CBOE, as

institutional accounts are unable to fully hedge their stock holdings

due to the restrictive limits, investors are unnecessarily forced to

keep a portion of their portfolio at risk.

The Commission believes that the CBOE's proposal to expand the

hedge exemption is an appropriate method to accommodate the identified

needs of options market participants.\29\ By increasing the hedge

exemption, the Commission believes, large hedge funds and institutional

accounts will be provided with the means necessary to adequately hedge

their stock holdings without adding risk to the options market.

\29\ See Study, supra note 17, at 4 and 6.

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Lastly, the Commission notes that despite an appreciable growth in

equity options trading and the sophisticated and automated surveillance

procedures employed by the Exchange, the last change in position limits

occurred in 1993. Based on the CBOE's experience, the Commission

believes that the proposed increased hedge exemption and additional

limit tiers should result in little or no additional risk to the

marketplace.\30\

\30\ The Commission notes that to the extent the potential for

manipulation increases because of the additional tiers and expanded

hedge exemption, the Commission believes the Exchange's surveillance

programs will be adequate to detect as well as to deter attempted

manipulative activity. The Commission will, of course, continue to

monitor the Exchange's surveillance programs to ensure that problems

do not arise.

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As noted above, Amendment No. 1 states that the CBOE will only

initially implement the changes being approved in this order for those

classes of options solely traded on the CBOE and that the revised

limits for multiply traded classes will only be effected uniformly on

all the options exchanges at an agreed upon date after Commission

approval of all necessary rule filing. The Commission believes this

approach is reasonable and balances the market need to expand position

and exercise limits and the hedge exemption, while continuing to ensure

that uniform position and exercise limits will exist among the options

exchanges for multiply traded classes.\31\

\31\ See supra note 7.

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The Commission finds good cause to approve Amendment No. 1 to the

proposed rule change prior to the thirtieth day after the date of

publication of notice of filing thereof in the Federal Register.

Specifically, by limiting the implementation of the increase in

position and exercise limits and the expanded hedge exemption to only

qualifying non-multiply traded options, pending approval of similar

proposals by the other options markets, Amendment No. 1 will ensure

that uniform position and exercise limits among the options exchanges

will exist for all multiply traded classes. Accordingly, the Commission

believes that it is consistent with Section 6(b)(5) of the Act to

approve Amendment No. 1 to the proposal on an accelerated basis.

Interested persons are invited to submit written data, views, and

arguments concerning Amendment No. 1 to the rule proposal. Persons

making written submissions should file six copies thereof with the

Secretary, Securities and Exchange Commission, 450 Fifth Street NW.,

Washington, DC 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 NW., Washington, DC 20549. Copies

of such filing also will be available for inspection and copying at the

principal office of the CBOE. All submissions should refer to File No.

SR-CBOE-95-42 and should be submitted by November 13, 1995.

V. Conclusion

For the foregoing reasons, the Commission finds that the CBOE's

proposal to add two position and position and exercise limit tiers for

qualifying equity option classes and to expand the equity option hedge

exemption, as well as to delay the implementation of the proposal for

multiply traded options classes, is consistent with the requirements of

the Act and the rules and regulations thereunder.

It is therefore ordered, pursuant to Section 19(b)(2) of the

Act,\32\ that the proposed rule change (SR-CBOE-95-

[[Page 54273]]

42), including Amendment No. 1, is approved.

\32\ 15 U.S.C. 78s(b)(2) (1988).

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For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\33\

\33\ 17 CFR 200.30-3(a)(12) (1994).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 95-26003 Filed 10-19-95; 8:45 am]

BILLING CODE 8010-01-M