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94-46 NASD Reminds Members Of Their Obligations When Trading Options
Given the growing market for over-the-counter (OTC) derivatives, such as OTC options on individual equity securities and stock indexes, and the Securities and Exchange Commission's (SEC) recent approval of increases in option position and exercise limits, the NASD reminds members of their obligations to comply with NASD rules governing options position limits, exercise limits, and position-reporting requirements. To clarify the application and operation of these rules, a description of the rules and a question and answer section follow. In addition, a reprint of the applicable rules follows this Notice.
Section 33 of the NASD Rules of Fair Practice governs members' activities in standardized and conventional options. Standardized options are exchange-traded options issued by the Options Clearing Corporation (OCC) that have standard terms for strike prices, expiration dates, and the amount of the underlying security. Presently, there are standardized options overlying individual equity securities, stock indexes, foreign currencies, American Depositary Receipts, exchange-listed closed-end country funds, Treasury instruments, and yields based on Treasury instruments. A conventional option is any other option contract not issued, or subject to issuance, by the OCC. Section 33(a), however, provides that the term "option" shall "not include any tender offer, registered warrant, right, convertible security, or any other option with respect to which the writer is the issuer of the security which may be purchased or sold upon the exercise of the option."
Pursuant to Section 33(b)(1)(A) of the Rules of Fair Practice the position limits, exercise limits, and reporting requirements described below apply to standardized and conventional stock and stock-index options in the following manner:
Options Position Limits
Section 33(b)(3) of the Rules of Fan-Practice imposes a ceiling or position limit on the number of conventional and standardized equity options contracts in each options class (i.e, puts or calls) on the same side of the market that a member, a customer, a person associated with a member, or a group of investors acting in concert can write or hold. Accordingly, long calls and short puts are aggregated and short calls and long puts are aggregated for position-limit purposes. The position limit for each stock is determined according to a "three-tiered" system that subjects more actively traded securities with larger public floats to higher position limits and less actively traded stocks to lower limits. The NASD rules do not specifically govern how a particular equity option falls within one of the three position-limit tiers. Rather, the NASD position-limit rule provides that the position limit established by an options exchange(s) for a particular equity option is the applicable position limit for purposes of the NASD rule.2 The position limit for a particular equity security can be obtained from OCC, the relevant options exchange(s), or the NASD Market Surveillance Department. In instances where an equity security is not subject to standardized options trading and, thus, there is no position limit established by an options exchange, the applicable position limit for the conventional option is the lowest tier.
On January 5, 1994, the SEC approved an NASD proposal to increase the current position limits from 3,000,5,500, and 8,000 contracts to 4,500,7,500, and 10,500 contracts, respectively.3 These changes were made to track corresponding position limit increases made by the options exchanges. The NASD believes the increased position limits will afford market participants greater flexibility to employ larger options positions when effectuating their investment strategies. In addition, the NASD believes the increased limits likely will facilitate greater activity in exchange-listed options, thereby enhancing liquidity in the markets for exchange-traded options and the securities underlying those options.
The NASD hedge-exemption pilot program, in effect since February 1990, provides for an automatic exemption from equity option position limits for accounts that have established one of the four most commonly used hedged positions on a limited one-for-one basis (i.e., 100 shares of stock for one option contract or, in the case of an adjusted options contract, the number of shares represented by the adjusted contract). The exempted hedge positions are: (1) long stock/short calls; (2) long stock/long puts; (3) short stock/long calls; and (4) short stock/short puts. Under the pilot program, the largest options position that may be established (combining hedged and unhedged positions) may not exceed twice the basic position limit (i.e, 9,000,15,000, and 21,000 contracts, respectively).
On March 18, 1994, the SEC approved an NASD proposal to extend and expand its equity option position-limit, hedge-exemption pilot program.4 Specifically, the pilot program was extended until December 31, 1995, and expanded to provide that the underlying hedged security position may be comprised of securities readily convertible into, or economically equivalent to, the security underlying the corresponding hedging options position. The NASD believes that expanding the hedge-exemption pilot program in this manner will allow investors to hedge instruments that are economically equivalent to stocks more efficiently and effectively. Because the value of a convertible security likely will fluctuate in tandem with the value of the security that it is convertible into, the NASD believes investors with positions in convertible securities should be able to hedge their positions with equity options to the same extent that investors with long or short positions in the underlying security can.5
Conventional stock-index options are not subject to position limits, although members trading standardized stock-index options are required to adhere to the position limits established for the option by the exchange on which it trades.
Options Exercise Limits
Options exercise limits restrict the number of options contracts that a member, customer, person associated with a member, or group of investors acting in concert can exercise within five consecutive business days. Under Section 33(b)(4) of the Rules of Fair Practice, the exercise limits correspond to position limits, such that investors in options classes on the same side of the market are allowed to exercise, during any five consecutive business days, only the number of options contracts set forth as the applicable position limit for those options classes. Accordingly, the SEC's approval of the NASD proposal for higher position limits also increased the NASD exercise limits to 4,500,7,500, and 10,500 contracts, respectively.
Under the hedge-exemption pilot program for equity options, the exercise limit is equivalent to the size of the options position established pursuant to the hedge-exemption program. Therefore, if the position limit for an option is 7,500 contracts and an investor has established a position of 10,000 contracts (7,500 unhedged and 2,500 hedged), the investor could exercise all 10,000 contracts during five consecutive business days.
As with position limits, standardized and conventional equity options and standardized stock-index options are subject to exercise limits, while conventional stock-index options are not.
Options Position Reporting
Section 33(b)(4) of the Rules of Fair Practice is applicable to all standardized options positions established by "access" firms6 or their customers and all conventional options positions established by members or their customers. Specifically, the rule requires members to file a report with the NASD if the member's account, a customer's account, or an associated person's account establishes an aggregate options position of 200 or more options contracts of the put class and the call class on the same side of the market covering the same underlying security or index.
In aggregating options on the "same side of the market," long calls in any class of options should be combined with short puts of the same class and short calls should be combined with long puts to determine whether a reportable position exists. Long and short positions for the same class should not be netted or combined (e.g., 200 contracts long and 200 contracts short in the same options class in the same account should both be reported, while 100 contracts long and 100 contracts short in the same options class in the same account should not be reported).
A position report form should be filed in each of the following situations:
- A long and/or short position of 200 or more options contracts of the put class and the call class on the same side of the market is established in the account.
- There is an increase in a previously reported position (e.g., from 250 contracts to 275 contracts).
- There is a decrease in a previously reported position to a position of less than 200 contracts (e.g., from 250 contracts to 199 contracts). Once a position has been reduced to less than 200 contracts, no subsequent position reports would have to be filed until the account once again established a long and/or short position of 200 or more contracts of the put class and the call class on the same side of the market.
Position report forms and instructions can be obtained by contacting Joseph Alotto, Special Investigator, NASD Market Surveillance Department, at (301) 590-6845.
Section 33(b)(3)(A) of the Rules of Fair Practice provides that the NASD may grant position-limit exemptions in "highly unusual circumstances." Position-limit exemption requests are considered by the Options and Derivatives Subcommittee (Options Subcommittee) of the NASD Trading Committee on a confidential basis. A position-limit exemption request should contain, at a minimum: (1) the size of the position-limit exemption request; (2) the name of the security underlying the option or sufficient information about the underlying security to enable the Options Subcommittee to adequately assess the market for that security (i.e., float, market capitalization, price, primary market, trading volume, etc.); (3) a description of the parties to the transaction; (4) the basis for the exemption; and (5) a statement as to why the market disruption and manipulation concerns underlying position limits would not be compromised if the NASD were to grant the exemption. Depending on the circumstances, the Options Subcommittee also may ask for additional information. Members submitting position-limit exemption requests should direct them to either Glen Shipway, Senior Vice President, Market Operations, The Nasdaq Stock Market, 80 Merritt Boulevard, Trumbull, CT 06611, or Thomas Gira, Assistant General Counsel, The Nasdaq Stock Market, 1735 K Street, N.W., Washington, D.C. 20006.
As a general matter, the NASD has not granted many position-limit exemptions in the past. Recently, however, the Options Subcommittee has been considering an increasing number of exemption requests. Accordingly, in the interests of keeping market participants equally informed of actions taken by the Options Subcommittee in this area, the NASD will publish generic descriptions of the position-limit exemptions and interpretive positions issued by the Options Subcommittee, as well as those requests denied by the Subcommittee, from time to time, in the "For Your Information" section of NASD Notices to Members. Members and customers of members are reminded that these exemptions and interpretations are fact specific in nature and, therefore, it would be a violation of the NASD position-limit rule if a member or customer were to rely solely on a generic description of a position-limit exemption or interpretive position without also obtaining a specific position-limit exemption or interpretive position from the Options Subcommittee. Following are brief summaries of recent actions taken by the Options Subcommittee in this area.
"Collar Transaction" Involving Conventional Options
The Options Subcommittee considered and granted several exemption requests concerning the aggregation of long put and short call positions in the context of "collar" transactions involving cash-settled, European-style conventional options. In these transactions, the customer purchased long puts and wrote short calls on the same amount of the underlying security to hedge a long stock position. Specifically, the Options Subcommittee determined that, subject to the following conditions and consultation with the NASD on a case-by-case basis, short call and long put positions in a conventional option collar transaction need not be aggregated. Provided that all the conditions are satisfied, the Options Subcommittee also determined that corresponding long call and short put positions in conventional options established to facilitate the collar likewise need not be aggregated. The conditions are as follows:
Non-Applicability Of Section 33 Of The Rules Of Fair Practice To Certain Equity Warrants
The Options Subcommittee issued an interpretive position that Section 33 of the Rules of Fair Practice does not apply to warrants issued by a large, publicly held U.S. company on the common stock of a non-U.S. company in which the U.S. company has a 20 percent ownership interest. The Options Subcommittee found that the 20 percent ownership of the non-U.S. company by the U.S. company brought the warrants within the "issuer written" exemption contained in Section 33(a) of the NASD Rules of Fair Practice.
Application Of The Position-Limit, Hedge-Exemption Program To Call Options Purchased By Issuers On Their Own Stock
The Options Subcommittee issued an interpretive position that an issuer may be deemed to be short its own stock when purchasing call options on its stock to hedge market exposure from employee stock options, stock repurchase programs, and outstanding convertible securities, and for other corporate purposes. Thus, for purposes of the hedge-exemption program, an issuer could purchase calls on its own stock up to twice the applicable limit because it would be deemed to be short the requisite number of shares of stock. This interpretive position should not, however, be construed to be an opinion by the Options Subcommittee with respect to the applicability of SEC Rule 10b-18 to issuers purchasing call options on their own stock, or to purchases by writers of such calls to hedge their position or to acquire stock to deliver upon exercise of the call option. Accordingly, the Option Subcommittee's interpretive position in no way affects or changes the operation of any provision of SEC Rule 10b-18 or the availability of the safe harbor afforded by the rule. It is up to NASD members and issuers to determine when they are within the parameters of the safe harbor afforded by SEC Rule 10b-18.
Answers To Common Questions Concerning Position-Limits, Exercise Limits, And Reporting Requirements
Scope Of The NASD Options Rules
Aggregation Of Positions
Questions concerning this Notice may be directed to Thomas Gira, Assistant General Counsel, Office of General Counsel, at (202) 728-8957 or Joseph Alotto, Special Investigator, Market Surveillance, at (301) 590-6845.
1 "Access" firms are NASD members that conduct a business in exchange-listed options but which are not members of any of the options exchanges upon which the options are listed and traded.
2 For a description of the trading volume and float parameters used to determine applicable equity option position limits, see, e.g., Commentary .07 to American Stock Exchange Rule 904 and Interpretations and Policies .02 to Chicago Board Options Exchange Rule 4.11.
3 See Securities Exchange Act Release No. 33432 (January 5, 1994), 59 FR 1979.
4 See Securities Exchange Act Release No. 33783 (March 18, 1994), 59 FR 14229.
5 The NASD will determine on a case-by-case basis whether an instrument that is being used as the basis for the underlying hedged position is readily convertible into, or economically equivalent to, the security underlying the corresponding option position. In this connection, the NASD will find that an instrument which is not presently convertible into a security, but which will be at a future date, is not a readily "convertible" security for purposes of the hedge-exemption pilot program. In addition, the NASD notes that if a convertible security used to hedge an option position is called for redemption by the issuer, the security would have to be converted into the underlying security immediately or the corresponding option position reduced accordingly. For further guidance in this area, see also the NASD Board of Governor's Prompt Receipt and Delivery of Securities Interpretation issued under Article HI, Section 1 of the NASD Rules of Fair Practice. Specifically, Section (b)(5)(a) of the Interpretation provides some guidelines as to positions that are bona fide fully hedged for purposes of the NASD "affirmative determination" requirements for short sales. While Section (b)(5)(a) of the Interpretation provides some guidance, the staff must determine on a case-by-case basis whether an instrument is readily convertible into, or economically equivalent to, the security underlying the corresponding hedging options position.
6 See, supra, note 1.
Text Of Amendments To Section 33 Of The NASD Rules Of Fair Practice
(Note: New language is underlined; deletions are in brackets.)
Section 33(b)(3) Position Limits
In determining compliance with this subparagraph (3), option contracts on a market index displayed in the Nasdaq [NASDAQ] System shall be subject to a contract limitation fixed by the Corporation, which shall not be larger than the equivalent of a $300 million position. For this purpose, a position shall be determined by the product of the closing index value times the index multiplier times the number of contracts on the same side of the market.
Section 33(b)(4) Exercise Limits Except in highly unusual circumstances and with the prior written approval of the Corporation, in each instance, no member or person associated with a member shall exercise, for any account in which such member or person associated with a member has an interest, or for the account of any partner, officer, director or employee thereof or for the account of any customer, any option contract if as a result thereof such member or partner, officer, director or employee thereof or customer, acting alone or in concert with others, directly or indirectly, has or will have exercised within any five (5) consecutive business days a number of option contracts of a particular class of options in excess of the limits for options positions in subparagraph (b)(3). The Corporation may institute other limitations concerning the exercise of option contracts from time to time by action of the Corporation. Reasonable notice shall be given of each new limitation fixed by the Corporation.
Section 33(b)(5) Reporting of Options Positions
Such report shall identify the person or persons having an interest in such account and shall identify separately the total number of option contracts of each such class comprising the reportable position in such account. The report shall be in such form as may be prescribed by the Corporation and shall be filed no later than the close of business on the next business day following the day on which the transaction or transactions requiring the filing of such report occurred. Whenever a report shall be required to be filed with respect to an account pursuant to this subsection, the member filing such shall file with the Corporation such additional periodic reports with respect to such account as the Corporation may from time to time prescribe.