[Federal Register Volume 62, Number 176 (Thursday, September 11, 1997)]
[Notices]
[Pages 47840-47845]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-24038]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-39011; File No. SR-CBOE-97-26]
Self-Regulatory Organizations; Order Granting Approval to
Proposed Rule Change and Notice of Filing and Order Granting
Accelerated Approval to Amendment Nos. 1 and 2 to the Proposed Rule
Change by the Chicago Board Options Exchange, Inc., Relating to Listing
and Trading of Regular and Long-Term Index Options and FLEX Options on
the Dow Jones Industrial Average
September 3, 1997.
I. Introduction
On June 23, 1997, 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 list and trade cash-settled,
European-style stock index options on the Dow Jones Industrial Average
(``DJIA'' or ``Index''), a broad-based, price-weighted index comprised
of 30 large companies traded on the New York Stock Exchange (``NYSE''),
as more fully described below. The CBOE is also proposing to trade
long-term index options series (``LEAPS'') in the Index as
well as flexible exchange options (``FLEX Options'') on the Index.
---------------------------------------------------------------------------
\1\ 15 U.S.C. 78s(b)(1).
\2\ 17CFR 240.19b-4.
---------------------------------------------------------------------------
The proposed rule change, together with the substance of the
proposal, was published for comment in Securities Exchange Act Release
No. 38789 (June 30, 1997), 62 FR 36588 (July 8, 1997). No comment
letters were received in response to the proposal. The Exchange
subsequently filed Amendment Nos. 1 and 2 to the proposed rule change
on August 12, 1997 \3\ and August 12, 1997,\4\ respectively. This order
approves the proposal, as amended, and solicits comments on Amendment
Nos. 1 and 2.
---------------------------------------------------------------------------
\3\ Amendment No. 1 states that the Exchange will notify the
Commission if any of the following occur: the market value of any
component stock is less than $75 million and that component is not
options eligible; less than 80% of the weight of the Index is
represented by component stocks that are eligible for options
trading; 10% or more of the weight of the index is represented by
component stocks trading less than 20,000 shares per day; the
largest component stock accounts for more than 15% of the weight of
the index or the largest five components in the aggregate account
for more than 50% of the weight of the Index; and if the Index
decreases to less than 20 component stocks. In addition, Amendment
No. 1 amends CBOE Rule 6.42, Interpretation and Policy .03, to
provide that the minimum increment for bids and offers for options
on the Dow Jones Industrial Average (``DJIA'') price at $3 or above
shall be in eighths, unless the Exchange determines that the minimum
increment should be reduced to sixteenths. Finally, CBOE has
attached to Amendment No. 1 a letter from Dow Jones & Company, Inc.
(``Dow Jones'') describing its procedures for replacing Index
components and stating the conflicts-of-interest policy regarding
its employees. See letter from Eileen Smith, Director, Product
Development, CBOE, to John Ayanian, Special Counsel, Market
Regulation, Commission, dated August 1, 1997 (``Amendment No. 1'').
\4\ Amendment No. 2 states that with respect to trading DJIA
options in increments of sixteenths of a dollar for options greater
than $3, the CBOE Board of Directors will make the determination to
allow trading in options on the DJIA in sixteenths. In addition,
CBOE will notify members and member firms of the Board's decision to
trade DJIA options in sixteenths at least one week prior to
implementing the change. Also, CBOE will make a rule change under
Section 19(b)(3)(A) of the Act prior to the time the change goes
into effect and will make any additional filings necessary to
conform its Rules to the fact that trading in DJIA options will take
place in sixteenths. Amendment No. 2 also deletes the reference to
LEAPS on the DJIA from Rule 24.9(b)(2), the reduced-value LEAPS
section, to reflect the fact that there will be no reduced-value
LEAPS trading on the DJIA. See letter from Eileen Smith, Director,
Product Development, CBOE, to John Ayanian, Special Counsel, Market
Regulation, Commission, dated August 8, 1997 (``Amendment No. 2'').
---------------------------------------------------------------------------
II. Background and Description
CBOE hereby proposes to amend certain of its rules to provide for
the listing and trading on the Exchange of options on the DJIA, a
broad-based index designed by Dow Jones & Company, Inc. (``Dow Jones
TM.\5\) Options on the DJIA TM will be cash-
settled and will have European-style exercise provisions. The Exchange
also proposes to amend its rules to provide for the trading of FLEX
Options on the DJIA. The DJIA is a price-weighted index of thirty of
the largest, most liquid
[[Page 47841]]
stocks traded on organized U.S. securities markets. \6\ Options
initially will be based on one-one hundredth of the DJIA. CBOE's
proposal also permits it to trade Index options on an underlying level
of one-tenth of the value of the DJIA. CBOE indicates, however, that it
does not intend to immediately trade such options contracts and states
in its rule filing that these contracts may be introduced at a later
date. CBOE stated that its purpose in getting approval to trade options
based on either one-one-hundredth or one-tenth of the value of the DJIA
is to offer contracts which appeal to both retail and institutional
investors. If CBOE were to trade options based on both one-one-
hundredth and one-tenth the value of the DJIA, each contract would have
a different ticker symbol to eliminate any potential confusion.
---------------------------------------------------------------------------
\5\ ``Dow Jones,'' and ``Dow Jones Industrial
AverageTM'' are trademarks of Dow Jones & Company, Inc.
and have been licensed for use for certain purposes by CBOE. CBOE's
options based on the Dow Jones Industrial Average are not sponsored,
endorsed, sold or promoted by Dow Jones, and Dow Jones makes no
representation regarding the advisability of investing in such
products.
\6\ The DJIA currently consists of the following companies:
Allied Signal, Incorporated; Aluminum Company of America; American
Express Company; AT&T Corporation; Boeing Company; Caterpiller,
Incorporated; Chevron Corporation; Coca Cola Company; Du Pont Ei de
Nemours; Eastman Kodak Company; Exxon Corporation; General Electric
Company; General Motors Corporation; Goodyear Tire and Rubber
Company; Hewlett Packard Company; IBM International Business
Machines; International Paper Company; Johnson and Johnson; JP
Morgan and Company, Incorporated; McDonalds Corporation; Merck and
Company, Incorporated; Minnesota Mining and Manufacturing; Philip
Morris Companies, Incorporated; Procter and Gamble Company; Sears
Roebuck and Company; Travelers Group, Incorporated; Union Carbide
Corporation; United Technologies Corporation; Wal Mart Stores,
Incorporated; and Walt Disney Company.
---------------------------------------------------------------------------
Index Design. The DJIA has been designed to measure the performance
of certain high capitalization stocks. The DJIA has been calculated by
Dow Jones & Company since 1896 and, according to CBOE, is the most
commonly watch index of the U.S. stock market. The DJIA is a price-
weighted index with each stock affecting the Index in proportion to its
market price. Each stock in the Index is currently trading on the NYSE
and is eligible for options trading. All component stocks are
``reported securities,'' as that term is defined in Rule 11Aa3-1 of the
Act.\7\
---------------------------------------------------------------------------
\7\ See 17 CFR 240.11Aa3-1. A ``reported security'' is defined
in paragraph (a)(4) of this rule as ``any listed equity security or
Nasdaq security for which transaction reports are required to be
made on a real-time basis pursuant to an effective transaction
reporting plan.'' A ``transaction reporting plan'' is defined in
paragraph (a)(2) of this rule as ``any plan for collecting,
processing, making available or disseminating transaction reports
with respect to transactions in reported securities filed with the
Commission pursuant to, and meeting the requirements of, this
Section.''
---------------------------------------------------------------------------
As of June 5, 1997, the 30 stocks in the Index ranged in
capitalization from $5.9 billion to $200.0 billion. The total market
capitalization of the Index was $1.7 trillion, the average
capitalization of the firms in the Index was $57.0 billion and the
median capitalization was $40.6 billion. The largest stock accounted
for 6.30% of the total weight of the Index, while the smallest
accounted for 1.46%. The top 5 components accounted for 26.18% of the
weight of the Index. In addition, the average daily trading volume for
the component stocks over the six-month period from December 1996 to
May 1997 ranged from a high of approximately 8.2 million (Philip
Morris) to a low of approximately 515,000 (Goodyear Tire and Rubber
Co.).
Calculation. The DJIA is a price-weighted index. The level of the
Index reflects the total price of the component stocks divided by the
Index Divisor. The DJIA was first calculated on May 26, 1896 and the
Index value was 40.94 on that date. The Index had a closing value of
7305.29 on June 5, 1997.\8\ The daily calculation of the DJIA Index is
computed by dividing the aggregate price of the companies in the Index
by the Index Divisor. the Divisor keeps the Index comparable over time
and is adjusted periodically to maintain the Index. The values of the
Index will be calculated by Dow Jones & Company or its designee and
will be disseminated at 15-second intervals during regular CBOE trading
hours to market information vendors via the Options Price Reporting
Authority (``OPRA'') or the Consolidated Tape Association (``CTA'').
---------------------------------------------------------------------------
\8\ The Commission notes that an option on the DJIA, valued at
one-one-hundredth of the value of the DJIA, would have a value
approximately equal to 73.05, assuming an Index value of 7305.29.
---------------------------------------------------------------------------
Maintenance. Dow Jones is responsible for maintenance of the DJIA.
Generally, Index components are replaced infrequently. The Managing
Editor of The Wall Street Journal is responsible for component
additions and deletions. The Managing Editor selects the stocks he
believes best reflect the industrial sector of the economy and of the
stock market; though various data might be gathered for reference, this
is a subjective decision.\9\ The stocks are not formally reviewed on
any set schedule. Index maintenance includes monitoring and completing
the adjustments for company additions and deletions, stock splits,
stock dividends (other than an ordinary cash dividend), and stock price
adjustments due to company restructuring or spinoffs. In almost all
instances, a stock is removed immediately from the DJIA when the
company files for protection under bankruptcy laws. If required, the
Index Divisor will be adjusted to account for any of the above changes.
These changes are announced in The Wall Street Journal and through the
Dow Jones News Service generally three to five days prior to
implementation. The DJIA has been composed of 30 stocks since 1928 and
it is expected that it will remain at 30 stocks.
---------------------------------------------------------------------------
\9\ See Amendment No. 1 supra note 3.
---------------------------------------------------------------------------
In addition, the Exchange will notify the Commission if any of the
following occur: the market value of any component stock is less than
$75 million and that component is not options eligible; less than 80%
of the weight of the Index is represented by component stocks that are
eligible for options trading; 10% or more of the weight of the Index is
represented by component stocks trading less than 20,000 shares per
day; the largest component stock accounts for more than 15% of the
weight of the Index or the largest five components in the aggregate
account for more than 50% of the weight of the Index; and the Index
decreases to less than 20 component stocks.\10\
---------------------------------------------------------------------------
\10\ See Amendment No. 1, supra note 3.
---------------------------------------------------------------------------
Index Option Trading. In addition to regular Index options, the
Exchange may provide for the listing of long-term Index option series
(``LEAPS''). For LEAPS, the underlying value would be
computed by using the same levels as proposed for the Index options;
one-tenth or one-one-hundredth of the DJIA, as applicable.\11\ The
current and closing Index value of any such LEAP will, after such
initial computation, be rounded to the nearest one-hundredth.
---------------------------------------------------------------------------
\11\ The Exchange is not proposing to trade reduced value LEAPS
on the DJIA.
---------------------------------------------------------------------------
The Exchange also is proposing to list FLEX Index options on the
DJIA. FLEX options give investors the ability, within specified limits,
to designate certain of the terms of the options. In recent years, an
over-the counter (``OTC'') market in customized options has developed
which permits participants to designate the basic terms of the options,
including size, term to expiration, exercise style, exercise price, and
exercise settlement value, in order to meet their individual investment
needs. Participants in this OTC market are typically institutional
investors, who buy and sell options in large-size transactions through
a relatively small number of securities dealers. To compete with this
growing OTC market in customized options, the CBOE permits FLEX Index
options trading in an exchange auction market environment, with The
Options Clearing Corporation (``OCC'') as issuer and
[[Page 47842]]
guarantor.\12\ The Exchange's proposal will allow FLEX option market
participants to designate the following contract terms for FLEX options
on the DJIA: (1) exercise price; (2) exercise style (i.e.,
American,\13\ European,\14\ or capped \15\); (3) expiration date; \16\
(4) option type (put, call, or spread); and (5) form of settlement
(A.M., P.M. or average).
---------------------------------------------------------------------------
\12\ The Commission has previously designated FLEX index options
as standardized options for the purposes of the options disclosure
framework established under Rule 9b-1 of the Act. See Securities
Exchange Act Release No. 31910 (February 23, 1993), 58 FR 12056
(March 2, 1993). In addition, the Commission has approved the
listing by CBOE of FLEX Index options on the S&P 100 (``OEX''), S&P
500 (``SPX''), Nasdaq 100, and Russell 2000 Indexes. See Securities
Exchange Act Release Nos. 31920 (February 24, 1993), 58 FR 12280
(March 3, 1993) (approval of FLEX options on the SPX and OEX
indexes); 34052 (May 12, 1994), 59 FR 25972 (May 18, 1994) (approval
of FLEX options on the Nasdaq 100 index); and 32694 (July 29, 1993),
58 FR 41814 (August 5, 1993) (approval of FLEX options on the
Russell 2000 index).
\13\ An American-style option is one that may be exercised at
any time on or before the expiration date.
\14\ A European-style option is one that may be exercised only
during a limited period of time prior to expiration of the option.
\15\ A capped-style index option is one that is automatically
exercised prior to expiration when the cap index value is less than
or equal to the index value for calls or when the cap index value is
greater than or equal to the index value for puts.
\16\ The expiration date of a FLEX option may not fall on a day
that is on, or within two business days, of the expiration date of a
Non-FLEX option.
---------------------------------------------------------------------------
Strike prices for options based on one-one-hundredth of the Index
will be set to bracket the Index in \1/2\ point increments or greater.
CBOE notes that these \1/2\ point increments correspond to 5-point
increments in other broad-based index options, such as the Standard &
Poor's 100 (``S&P 100'') Index and Standard & Poor's 500 (``S&P 500'')
Index, because the size of the contract will be approximately one-tenth
of the size of the option contracts on those other broad-based indexes.
Strike prices for options based on one-tenth of the Index will be set
in 5-point increments. The trading hours for options on the Index will
be from 8:30 a.m. to 3:15 p.m. Chicago time. Options based on the DJIA
will be listed in up to three near-term months plus up to three months
from the March quarterly cycle.
The Exchange is also proposing to add an interpretation to Rule
6.42 to establish that the minimum increment for bids and offers in the
DJIA priced at or above $3 shall be in eighths of a dollar, unless the
Exchange determines that the minimum increment for these options should
be reduced to sixteenths of a dollar.\17\ Rule 6.42 currently requires
bids and offers to be expressed in eights of $1, except for those
series trading below $3. Under CBOE's proposal, the Board of Directors
will have the authority to allow the trading of DJIA options in
sixteenths of a dollar, and CBOE will notify its members and member
firms at least one week prior to implementing such a change. In
addition, CBOE will make a rule change filing under Section 19(b)(3)(A)
of the Act prior to the time the change goes into effect, and will make
any additional filings necessary to conform its Rules to the fact that
trading in DJIA options will be changed from increments of eighths to
sixteenths of a dollar.\18\
---------------------------------------------------------------------------
\17\ See Amendment No. 1, supra note 3. The Commission notes
that the original proposal was to have a minimum trading increment
for all bids and offers in the DJIA, regardless of price, in
sixteenths of a dollar.
\18\ See Amendment No. 2, supra note 4.
---------------------------------------------------------------------------
Exercise and Settlement. The proposed options on the Index will
expire on the Saturday following the third Friday of the expiration
month. Trading in the expiring contract month will normally cease at
3:15 p.m. (Chicago time) on the business day preceding the last day of
trading in the component securities of the Index (ordinarily the
Thursday before expiration Saturday, unless there is an intervening
holiday). The exercise settlement value of the Index at option
expiration will be calculated by Dow Jones \19\ based on the opening
prices of the component securities on the business day prior to
expiration. If a stock fails to open for trading, the last available
price on the stock will be used in the calculation of the Index, as is
done for currently listed indexes.\20\ When the last trading day is
moved because of Exchange holidays (such as when CBOE is closed on the
Friday before expiration), the last trading day for expiring options
will be Wednesday and the exercise settlement value of Index options at
expiration will be determined at the opening of regular Thursday
trading.
---------------------------------------------------------------------------
\19\ Phone conversation between Eileen Smith, Director, Research
and Product Development, CBOE, and Heather Seidel, Attorney, Market
Regulation, Commission, on June 30, 1997.
\20\ The Commission notes that pursuant to Article XVII, Section
4 of the OCC by-laws, OCC is empowered to fix an exercise settlement
amount in the event it determines a current index value is
unreported or otherwise unavailable. Further, OCC has the authority
to fix an exercise settlement amount whenever the primary market for
the securities representing a substantial part of the value of an
underlying index is not open for trading at the time when the
current index value (i.e., the value used for exercise settlement
purposes) ordinarily would be determined. See Securities and
Exchange Act Release No. 37315 (June 17, 1996), 61 FR 42671 (order
approving SR-OCC-95-19).
---------------------------------------------------------------------------
Surveillance. The Exchange will use the same surveillance
procedures currently utilized for each of the Exchange's other index
options to monitor trading in Index options and Index LEAPS. In
addition, the Exchange will use the same surveillance procedures
currently utilized for each of the Exchange's other FLEX index options
to monitor trading in FLEX options on the DJIA. These procedures
include complete access to trading activity in the underlying
securities. Further, the Intermarket Surveillance Group (``ISG'')
Agreement, dated July 14, 1983, as amended on January 23, 1990, will be
applicable to the trading of options on the Index.\21\
---------------------------------------------------------------------------
\21\ The ISG was formed on July 14, 1983 to, among other things,
coordinate more effectively surveillance and investigative
information sharing arrangements in the stock and options markets.
See Intermarket Surveillance Group Agreement, dated July 14, 1983,
amended January 29, 1990. The members of the ISG are the following:
the American Stock Exchange, Inc.; the Boston Stock Exchange, Inc.;
the CBOE; the Chicago Stock Exchange, Inc.; the National Association
of Securities Dealers, Inc.; the NYSE; the Pacific Stock Exchange
Inc.; and the Philadelphia Stock Exchange, Inc. The major stock
index futures exchanges (including the Chicago Mercantile Exchange
and the Chicago Board of Trade) joined the ISG as affiliate members
in 1990.
---------------------------------------------------------------------------
Dow Jones & Company also has a policy in place to prevent the
potential misuse of material, non-public information by members of the
Wall Street Journal managerial and editorial staff in connection with
the maintenance of the Index. Specifically, the managerial and
editorial staff of the Wall Street Journal are subject to the Dow Jones
& Company conflicts-of-interest policy which prohibits, upon penalty of
dismissal, the use or dissemination of any vital information prior to
publication.\22\
---------------------------------------------------------------------------
\22\ See Amendment No. 1, supra note 3.
---------------------------------------------------------------------------
Position Limits. The Exchange proposes to establish position limits
for options on the DJIA at 1,000,000 contracts on either side of the
market for option contracts that are based on one-one hundredth of the
value of the DJIA and 100,000 for contracts based on one-tenth of the
value of the DJIA. Positions in options based on either level of the
DJIA will be aggregated for purposes of determining compliance with
position limits; positions in options based on one-tenth of the value
of the DJIA must be multiplied by a factor of 10, then aggregated with
options based on one-one hundredth of the value of the DJIA. The broad-
based index hedge exemption will be 2,500,000 contracts for options
based on one-one hundredth of the DJIA and 250,000 contracts for
options based on one-tenth of the DJIA. These limits are roughly
equivalent, in dollar terms, to the limits applicable to options on the
S&P 500 Index, a broad-based A.M.-settled index option.
[[Page 47843]]
FLEX Option Trading. The Exchange is proposing changes to its FLEX
rules to provide for the trading of FLEX options on the DJIA. The
proposed changes include an amendment to the FLEX Index option position
limits. The change would apply the same limits to positions in FLEX
options on the DJIA that exist for positions in other broad-based
indexes in the FLEX program; the limits are 200,000 contracts on the
same side of the market. For purposes of determining compliance with
these limits, every ten option contracts based on the one-one hundredth
of the DJIA will be counted as one contract.
Exchange Rules Applicable. As modified herein, the Rules in Chapter
XXIV will be applicable to options on the DJIA. Broad-based margin
rules will apply to the Index. The Exchange is proposing to amend
Chapter XXIV, Rule 24.14, Disclaimers, to identify Dow Jones and
Company, Inc. as the index reporting authority for the DJIA and other
Dow Jones products.
Capacity. CBOE believes it has the necessary systems capacity to
support new series that would result from the introduction of options
on the DJIA. CBOE has also been informed that OPRA also has the
capacity to support the new series.\23\ In making this determination,
the Exchange notes that OPRA has made, and is in the process of making,
significant enhancements to its capacity. These enhancements include:
upgrades to computers; additional lines to firms, vendors and
exchanges; and the introduction of new technology incorporating high
speed data transmission. All of these enhancements will be in place
prior to the scheduled introduction of these options contracts and will
give more than sufficient capacity to deal with these and other new
products.
---------------------------------------------------------------------------
\23\ See Exhibit D.
---------------------------------------------------------------------------
III. 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).\24\ Specifically,
the Commission finds that the trading of options on the DJIA, including
FLEX options \25\ and full-value LEAPS, will serve to promote the
public interest as well as to help remove impediments to a free and
open securities market. The Commission also believes that the trading
of options on the Index will allow investors holding positions in some
or all of the securities underlying the Index to hedge the risks
associated with their portfolios. Accordingly, the Commission believes
that DJIA Index options will provide investors with an important
trading and hedging mechanism.\26\ By broadening the hedging and
investment opportunities of investors, the Commission believes that the
trading of options on the DJIA will serve to protect investors, promote
the public interest, and contribute to the maintenance of fair and
orderly markets.\27\
---------------------------------------------------------------------------
\24\ 15 U.S.C. 78f(b)(5).
\25\ See discussion infra regarding FLEX options on the DJIA.
\26\ Pursuant to Section 6(b)(5) of the Act, the Commission must
predicate approval of any new securities product upon a finding that
the introduction of such product is in the public interest. Such a
finding would be difficult with respect to a product that served no
hedging or other economic function, because any benefits that might
be derived by market participants likely would be outweighed by the
potential for manipulation, diminished public confidence in the
integrity of the markets, and other valid regulatory concerns. In
this regard, the trading of listed Index options will provide
investors with a hedging vehicle that should reflect the overall
market of stocks representing a substantial segment of the U.S.
securities market.
\27\ In approving this rule, the Commission notes that it has
considered the proposed rule's impact on efficiency, competition,
and capital formation. 15 U.S.C. 78c(f).
---------------------------------------------------------------------------
Nevertheless, the trading of options, including FLEX Options and
full-value LEAPS, on the DJIA raises several issues related to the
design and structure of the Index, customer protection, surveillance,
and market impact. The Commission believes, however, for the reasons
discussed below, that the CBOE has adequately addressed these issues.
Index Design and Structure. The Commission believes that it is
appropriate for the Exchange to designate the DJIA as a broad-based
index for purposes of index option trading. Specifically, the
Commission believes that the Index is broad-based because it reflects a
substantial segment of the U.S. equities market. First, the Index
represents various diverse segments of the U.S. securities markets,
with 19 different industries represented by the Index's components,
such as chemicals and allied products, motion picture production,
eating and drinking places, transportation equipment, and industrial/
commercial machinery and computer equipment. Second, the Index consists
of 30 actively-traded stocks that are currently all options
eligible.\28\ Third, the Index, which is designated to track the
overall U.S. Market, is composed of highly capitalized, actively traded
securities. Specifically, the total capitalization of the Index as of
June 5, 1997, was approximately $1.7 trillion, representing
approximately one-fifth of the U.S. equity market. Market
capitalization of the individual stocks ranges from $5.9 billion to
$200 billion, with an average capitalization of $57 billion. As of the
same date, the six-month average daily trading volume for each
component in the Index ranged from a low of approximately 515,000 to a
high of 8.2 million. Fourth, no stock or group of stocks dominates the
Index. Specifically, no single stock accounted for more than 6.30% of
the total price weight of the Index, and the five highest weighted
securities accounted for 26.18% of the price weight of the Index.
Accordingly, the Commission believes that it is appropriate for the
Exchange to classify the Index as broad-based and apply its rules
governing broad-based index options to trading in the Index options.
---------------------------------------------------------------------------
\28\ See Notice Release. The Exchange's option listing
standards, which are uniform among the options exchanges, provide
that a security underlying an option must, among other things, meet
the following requirements: (1) the public float must be at least 7
million shares; (2) there must be a minimum of 2,000 stockholders;
(3) trading volume must have been at least 2.4 million shares over
the preceding twelve months; and (4) the market price per share must
have been at least $7.50 for a majority of business days during the
preceding three calendar months. See Interpretation .01 to Exchange
Rule 5.3.
---------------------------------------------------------------------------
The Commission also believes that the general broad
diversification, capitalization, and highly liquid markets of the
Index's component stocks significantly minimize the potential for
manipulation of the Index. First, as discussed above, the Index
represents a broad cross-section of domestically traded high
capitalization stocks, with no single industry group or stock
dominating the Index.\29\ Second, all of the stocks that comprise the
Index are actively traded. Third, CBOE has represented that it will
notify the staff of the Commission when: (1) less than 80% of the
weight of the Index is options eligible; (2) 10% or more of the weight
of the Index is represented by stocks trading less than 20,000 shares
per day; (3) the market capitalization of any component falls below $75
million at a time the component is not options eligible; (4) the
largest component of the Index is greater than 15% of the weight of the
Index, or the top five components are greater than 50% of the weight of
the Index; or (5) if the Index decreases to less than 20 component
stocks.\30\ In the
[[Page 47844]]
event the Index fails to satisfy any of the criteria, CBOE will notify
the Commission to determine the appropriate regulatory response,
including but not limited to, prohibiting opening transactions, removal
of the securities from the Index, or discontinuing the listing of new
series of Index options.\31\
---------------------------------------------------------------------------
\29\ The Commission believes that, even though the Index is
price weighted, the high capitalization and active trading of the
component stocks minimize any manipulative concerns that may arise
due to the price weighting.
\30\ See Amendment No. 1, supra note 3. The Commission
recognizes that the capitalization and daily trading volume of the
Index's components currently far exceed these standards.
Nonetheless, the is similar to minimum maintenance criteria utilized
in maintaining a variety of index products to ensure an adequate
level of liquidity in the component stocks.
\31\ In addition, if the composition of the Index's underlying
securities was to substantially change, the Commission's decision
regarding the appropriateness of the Index's current maintenance
standards would be reevaluated, and whether additional approval
under Section 19(b) of the Act is necessary to continue to trade the
product.
---------------------------------------------------------------------------
Fifth, the Exchange has proposed reasonable position and exercise
limits for the Index options that will serve to minimize potential
manipulation and other market impact concerns. The position limits, at
1,000,000 contracts on either side of the market for options valued at
one-one-hundredth of the DJIA, are roughly equivalent in dollar terms
to the limits applicable to options on other similar indices.\32\
Accordingly, the Commission believes these factors minimize the
potential for manipulation because it is unlikely that attempted
manipulations of the prices of the Index components would affect
significantly the Index's value. Moreover, the surveillance procedures
discussed below should detect as well as deter potential manipulation
and other trading abuses.
---------------------------------------------------------------------------
\32\ The Commission notes that although the actual number of
contracts is much larger than that of other indexes, the dollar
value position and exercise limits are roughly equivalent to similar
broad-based indexes, such as the S&P 500 and 100 index options.
---------------------------------------------------------------------------
Customer Protection. The Commission believes that a regulatory
system designed to protect public customers must be in place before the
trading of sophisticated financial instruments, such as options on the
DJIA (including full-value FLEX Options and LEAPS), can commence on a
national securities exchange. The Commission notes that the trading of
standardized, exchange-traded options occurs in an environment that is
designed to ensure, among other things, that: (1) the special risks of
options are disclosed to public customers; (2) only investors capable
of evaluating and bearing the risks of options trading are engaged in
such trading; and (3) special compliance procedures are applicable to
options accounts. Accordingly, because the Index options, including
LEAPS, will be subject to the same regulatory regime as the other
standardized options currently traded on the CBOE, the Commission
believes that adequate safeguards are in place to ensure the protection
of investors in options on the DJIA.
Surveillance. The Commission generally believes that a
surveillance-sharing agreement between an exchange proposing to list a
stock index derivative and the exchange(s) trading the stocks
underlying the derivative product is an important measure for the
surveillance of the derivatives and underlying securities markets. Such
agreements ensure the availability of information necessary to detect
and to deter potential manipulations and other trading abuses, thereby
making the stock index product less readily susceptible to
manipulation.\33\ In this regard, the market upon which all of the
Index component stocks trade, the NYSE, is a member of the ISG.\34\
Similarly, the options on the individual component securities trade on
markets which are ISG members.
---------------------------------------------------------------------------
\33\ See, e.g., Securities Exchange Act Release No. 31243
(September 28, 1992), 57 FR 45849 (October 5, 1992) (CBOE-91-51)
(order approving the listing of options on the CBOE Biotech Index).
\34\ See supra note 14.
---------------------------------------------------------------------------
In addition, the Exchange will apply the same surveillance
procedures as those used for existing broad-based index option trading
on the CBOE. As noted above, Dow Jones & Company also has a policy in
place to prevent the potential misuse of material, non-public
information by members of the Wall Street Journal managerial and
editorial staff in connection with the maintenance of the Index.\35\
---------------------------------------------------------------------------
\35\ See Amendment No. 1, supra note 3.
---------------------------------------------------------------------------
Market-Impact. The Commission believes that the listing and trading
of options, including full-value LEAPS, on the DJIA will not adversely
impact the underlying securities markets.\36\ First, as described
above, the Index is broad-based and comprised of 30 stocks, with no one
stock dominating the Index. Second, as noted above, the stocks
contained in the Index have large capitalizations and are actively-
traded. Specifically, as noted above, the average daily trading volume
for the component stocks over the six month period from December 1996
to May 1997 ranged from a high of 8.2 million to a low of 515,000.\37\
Third, the 1,000,000 contract position and exercise limits for
contracts based on one-one-hundredth of the value of the DJIA will
serve to minimize potential manipulation and market impact concerns.
Fourth, currently all stocks comprising the Index are options eligible
and CBOE will notify the Commission if less than 80% of the Index
continues to be eligible for options trading. Fifth, the risk to
investors of contra-party non-performance will be minimized because the
Index options and LEAPS will be issued and guaranteed by the OCC,
similar to all other standardized options traded in the United States.
---------------------------------------------------------------------------
\36\ In addition, the CBOE has represented that it and OPRA have
the necessary systems capacity to support those new series of index
options that would result from the introduction of Index options and
FLEX Options.
\37\ Should 10% or more of the weight of the Index be composed
of stocks trading at less than 20,000 per day, CBOE will notify
Commission staff. See Amendment No. 1, supra note 3.
---------------------------------------------------------------------------
Lastly, the Commission believes that settling expiring Index
options based on the opening prices of component securities is
reasonable and consistent with the Act. As noted in other contexts,
valuing options for exercise settlement on expiration based on opening
prices rather than on closing prices may help reduce adverse effects on
markets for stocks underlying options on the Index.\38\
---------------------------------------------------------------------------
\38\ See, e.g., Securities Exchange Act Release No. 30944 (July
21, 1992), 57 FR 33376 (July 28, 1992) (CBOE-92-09) (order approving
position limits for European-style Standard & Poor's 500 Stock Index
options settled based on the opening prices of component
securities).
---------------------------------------------------------------------------
FLEX Options. The Commission also believes that the proposal to
list DJIA FLEX options should encourage fair competition among brokers
and dealers and exchange markets, by allowing the Exchange to compete
with the growing OTC market in customized index options.
The Commission believes the Exchange's proposal reasonably
addresses its desire to meet the demands of sophisticated portfolio
managers and other institutional investors who are increasingly using
the OTC market in order to satisfy their hedging needs. Additionally,
the Commission believes that the Exchange's proposal will help promote
the maintenance of a fair and orderly market, consistent with Sections
6(b)(5) and 11(a) of the Act, because the purpose of the proposal to
list DJIA FLEX options is to extend the benefits of a listed, exchange
market to index options that are more flexible than current listed
options and that currently trade OTC.\39\ The benefits of the
Exchange's options market include, but are not limited to, a
centralized market center, an auction market with posted transparent
market quotations and transaction reporting, parameters and procedures
for clearance and settlement,
[[Page 47845]]
and the guarantee of OCC for all contracts traded on the Exchange.
---------------------------------------------------------------------------
\39\ As noted above, FLEX options allow investors to customize
certain terms, including size, term to expiration, exercise style,
exercise price, and exercise settlement value.
---------------------------------------------------------------------------
The Commission notes that FLEX index options on the DJIA can be
constructed with expiration exercise settlement based on the closing
values of the component securities, which could potentially result in
adverse effects for the markets in these securities.\40\ Although the
Commission continues to believe that basing the settlement of index
products on opening as opposed to closing prices on Expiration Friday
helps alleviate stock market volatility, \41\ these market impact
concerns are reduced in the case of FLEX options on the DJIA because
expiration of these options will not correspond to the normal
expiration of any Non FLEX options (including options overlying the
DJIA), stock index futures, and options on stock index futures. In
particular, FLEX options, will never expire on any ``Expiration
Friday,'' because under CBOE rules the expiration date of a FLEX option
may not occur on a day that is on, or within, two business days of the
expiration date of a Non-FLEX option. The Commission believes that this
should reduce the possibility that the exercise of FLEX options at
expiration will cause any additional pressure on the market for
underlying securities at the same time Non-FLEX options expire.
---------------------------------------------------------------------------
\40\ See, e.g., Securities Exchange Act Release No. 30944 (July
21, 1992), 57 FR 33376 (July 28, 1992).
\41\ Id.
---------------------------------------------------------------------------
Nevertheless, because the position limits for FLEX index options on
the DJIA are much higher than those currently proposed for the
corresponding non-FLEX Index options and open interest in one or more
FLEX options on the DJIA might have an impact on the securities markets
for the securities underlying FLEX options. The Commission expects the
Exchange to monitor the actual effect of FLEX options on the DJIA once
trading commences and take prompt action (including timely
communication with the self-regulatory organizations responsible for
oversight of trading in the underlying securities) should any unusual
market effects develop.
Accelerated Approval of Amendment Nos. 1 and 2. The Commission
finds good cause to approve Amendment Nos. 1 and 2 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
stating that CBOE will notify the Commission in certain circumstances
regarding the weighting, capitalization, and number of DJIA component
stocks, specified above, and by describing Dow Jones procedures for
replacing component stocks, Amendment No. 1 will help to ensure that
the Commission receives adequate notice of material changes in
component stocks of the DJIA.
Amendment Nos. 1 and 2 also amend Interpretation and Policy .03
under CBOE Rule 6.42 to specify that the DJIA options priced at $3 or
above will be traded in eighths of a dollar, unless the CBOE Board of
Directors determines that the minimum increment shall be sixteenths of
a dollar; CBOE will give at least one week notice to its members and
member firms prior to implementing such a change and will file any
proposed rule changes necessary to conform its rules to such a change.
This portion of Amendment Nos. 1 and 2 clarifies the minimum trading
increment for DJIA options and the procedure by which CBOE, through its
Board, can modify that increment. It also ensures that investors will
have adequate notice of any changes in the trading increments as well
as that proposed rule change(s) under Section 19(b) of the Act will be
filed with the Commission as appropriate. The Commission further
believes that these proposed amendments raise no new regulatory issues.
Finally, the Commission notes that no comments were received on the
original CBOE proposal, which was subject to the full 21-day notice and
comment period. Accordingly, the Commission believes that it is
consistent with Sections 6(b)(5) and 19(b)(2) of the Act to approve
Amendment Nos. 1 and 2 to the proposal on an accelerated basis.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning Amendments Nos. 1 and 2 to the rule proposal.
Persons making written submissions should file six copies thereof with
the Secretary, Securities and Exchange Commission, 450 Fifth Street,
N.W., Washington, D.C. 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 Room. Copies of such filing also will be available for
inspection and copying at the principal office of the Exchange. All
submissions should refer to File No. SR-CBOE-97-26 and should be
submitted by October 2, 1997.
V. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\42\ that the proposed rule change (SR-CBOE-97-26) including
Amendment Nos. 1 and 2, is approved. In addition, for purposes of
trading FLEX Options on the Index, the Commission also finds, pursuant
to Rule 9b-1 under the Act, that such options are standardized options
for purposes of the options disclosure framework established under Rule
9b-1.
\42\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\43\
---------------------------------------------------------------------------
\43\ 17 CFR 200.30-3(a) (12) and (51).
---------------------------------------------------------------------------
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-24038 Filed 9-10-97; 8:45 am]
BILLING CODE 8010-01-M
