[Federal Register Volume 63, Number 246 (Wednesday, December 23, 1998)] [Notices] [Pages 71179-71181] From the Federal Register Online via the Government Publishing Office [www.gpo.gov] [FR Doc No: 98-33911] ----------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION [Release No. 34-40800; File No. SR-OCC-98-11] Self-Regulatory Organizations; The Options Clearing Corporation; Notice of Filing of Proposed Rule Change Regarding the Calculation of the Short Option Adjustment December 16, 1998. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (``Act''),\1\ notice is hereby given that on September 10, 1998, The Options Clearing Corp. (``OCC'') filed with the Securities and Exchange Commission (``Commission'') the proposed rule change as described in Items I, II, and III below, which items have been prepared primarily by OCC. The Commission is publishing this notice to solicit comments from interested persons on the proposed rule change. --------------------------------------------------------------------------- \1\ 15 U.S.C. 78s(b)(1). --------------------------------------------------------------------------- I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change Under the proposed rule change, OCC will amend the short option adjustment contained in OCC's Theoretical Intermarket Margin System (``TIMS'') to enable OCC to use a ``sliding scale'' to calculate short option adjustment amounts. II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change In its filing with the Commission, OCC included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. OCC has prepared summaries, set forth in sections (A), (B), and (C) below, of the most significant aspects of such statements.\2\ --------------------------------------------------------------------------- \2\ The Commission has modified the text of the summaries prepared by OCC. --------------------------------------------------------------------------- A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change Under the proposed rule change, OCC will amend Rules 601 and 602 to [[Page 71180]] provide OCC with more flexibility in calculating the amount of the short option adjustment.\3\ --------------------------------------------------------------------------- \3\ OCC Rule 601 describes TIMS as it applies to equity options (``equity TIMS'') and OCC Rule 602 describes TIMS as it applies to non-equity options (``non-equity TIMS''). --------------------------------------------------------------------------- OCC requires its clearing members to adjust their margin deposits with OCC in the morning of every business day based on OCC's overnight calculations. OCC imposes a margin requirement on short positions in each clearing member account and gives margin credit for unsegregated long positions.\4\ Under TIMS, the margin for positions in a class group is based on premium levels at the close of trading on the preceding day and is then increased or decreased by the additional margin amount for that class group.\5\ --------------------------------------------------------------------------- \4\ A long position is unsegregated for OCC's purposes if OCC has a lien on the position (i.e., has recourse to the value of the position in the event that the clearing member does not perform an obligation to OCC). Long positions in firm accounts and market-maker accounts are unsegregated. Long positions in the clearing member's customers' account are unsegregated only if the clearing member submits instructions to that effect in accordance with Rule 611. \5\ For purposes of equity TIMS, a class group consists of all put and call options, all BOUNDS, and all stock loan and borrow positions relating to the same underlying security. For purposes of non-equity TIMS, a class group consists of all put and call options, certain market baskets, and commodity options and futures (that are subject to margin at OCC because of a cross-margining program with a commodity clearing organization) that relate to the same underlying asset. A NEO TIMS class group may also contain stock loan baskets and stock borrow baskets. --------------------------------------------------------------------------- TIMS calculates additional margin amounts using options price theory. TIMS first calculates the theoretical liquidating value for the positions in each class group assuming either an increase or decrease in the market value of the underlying asset in an amount equal to the applicable margin interval. The margin interval is the maximum one day price movement that OCC wants to protect against in the price of the underlying asset.\6\ Margin intervals are determined separately for each underlying interest to reflect the volatility in the price of the underlying interest. --------------------------------------------------------------------------- \6\ Some combinations of positions can present a greater net theoretical liquidating value at an intermediate value than at either of the endpoint values. As a result, TIMS also calculates the theoretical liquidating value for the positions in each class group assuming intermediate market values of the underlying asset. --------------------------------------------------------------------------- TIMS then selects the theoretical liquidating value that represents the greatest decrease (where the actual liquidating value is positive) or increase (where the actual liquidating value is negative) in liquidating value compared with the actual liquidating value based on the premium levels at the close of trading on the preceding day. The difference between that theoretical liquidating value and the actual liquidating value is the additional margin amount for that class group unless the class group is subject to the short option adjustment. For net short positions \7\ in deep out of the money options, little or no change in value would be predicted given a change in value of the underlying interest equal to the applicable margin interval. As a result, TIMS would calculate additional margin amounts of zero or close to zero for deep out of the money options. However, volatile markets could cause such positions to become near to or in the money and thereby could create increased risk to OCC. OCC protects against such risk by incorporating into the additional margin calculation a margin cushion known as the short option adjustment.\8\ --------------------------------------------------------------------------- \7\ A net position in an option series in an account is the position resulting from offsetting the gross unsegregated long position in that series against the gross short position in that series. After netting, an account will reflect a net short position or a net long position for each series of options held in the account. \8\ The short option adjustment is described in Rule 601(c)(1)(C)(1) for equity options and Rule 602 (c)(1)(ii)(C)(1) for non-equity options. OCC recently amended Interpretation .06 to Rule 602 so that net short non-equity option positions can be paired off against net long non-equity positions whose underlying interests exhibit price correlation of at least seventy percent. Securities Exchange Act Release No. 40515 (September 30, 1988), 63 FR 53970. --------------------------------------------------------------------------- Currently, the short option adjustment requires a minimum additional margin amount equal to twenty-five percent of the applicable margin interval for all unpaired\9\ net short positions in options series for which the ordinary calculation of the additional margin requirement would be less than twenty-five percent of the applicable margin interval. OCC believes that this methodology requires clearing members to deposit margin in excess of the risk presented by some unpaired net short positions in out of the money options. --------------------------------------------------------------------------- \9\ The term unpaired is defined in Interpretation .04 to Rule 601 for equity options and Interpretation .06 to Rule 602 for non- equity options. --------------------------------------------------------------------------- OCC believes that this excess margin requirement can be attributed essentially to two causes. First, some short positions are so far out of the money that even an extreme market move would not cause them to prevent risk to OCC commensurate with a short option adjustment equivalent to twenty-five percent of the applicable margin interval. To illustrate, on October 27, 1997, the S&P 500 Index fell 6.9% to 876.98 from its closing value of 941.64 on October 24, 1997.\10\ There was a series of SPX 11/97 put options with an exercise price of 700 open on that date. At the close of October 24, 1997, that series was 25.7% out of the money and had a closing premium of $25.00. At the close on October 27, 1997, that series was 20.2% out of the money and had a closing premium of $56.25. The increase in the closing premium from October 24 to October 27 was $31.25. In the absence of the short option adjustment, TIMS would have required additional margin of $23.25. With the short option adjustment, TIMS required additional margin of $875.00 (equal to the margin interval, which was 35 points, times the index multiplier of 100, times 25%). Even in this extreme market move the short option adjustment required far more collateral than OCC needed to hedge the risk presented to it by unpaired short positions in this series. --------------------------------------------------------------------------- \10\ This market decline of 64.66 points was the 14th largest one day percentage decline in the period from January 1930 through June 1998, and it constituted a more extreme daily move than 99.9% of the daily moves during this period. The decline on October 27, 1997, actually represents a more rigorous test of the short option adjustment methodology than the market move on October 19, 1987. There are several reasons for this, such as the option implied volatility was so high on October 19, 1987, and the theoretical additional margin levels calculated by TIMS generally exceeded the alternative short option adjustment calculations. --------------------------------------------------------------------------- Second, out of the money short call positions present less risk to OCC than short put positions that are equally out of the money. This is essentially because a market that moves sharply down (presenting risk to OCC from short put positions) is generally associated with an increase in option implied volatility whereas a market that moves sharply up (presenting risk to OCC from short call positions) is generally associated with a decrease in option implied volatility. Other things being equal, an upward move in the market of a given size creates less risk for OCC from short call positions than a downward move in the market of the same size from short put positions. Therefore, because TIMS employs a twenty-five percent short option adjustment for both puts and calls, it tends to require excessive additional margin particularly with respect to short call positions. To address these situations, the proposed rule change will establish a sliding scale short option adjustment methodology. Using the sliding scale, the short option adjustment percentage will be applied to a particular series according to the extent to which the series is out of the money. In addition, OCC will use different sliding scales for put options and for call options. OCC believes that the margin required by these sliding scales should be sufficient to protect it against the risks [[Page 71181]] presented by out of the money short positions even in extreme market conditions. For example, in the illustration described above, the sliding scale short option adjustment would still have required additional margin of $350.00 (equal to the margin interval of 35 points, times the index multiplier of 100, times 10%, the applicable percentage for a short put 25.7% out of the market) which is well in excess of the risk presented to OCC by the short puts in the SPX 11/97 700 series. Under the proposed rule change, OCC will modify Rules 601 and 602 to provide that the short option adjustment to be applied to any unpaired short position will be determined using a percentage that OCC deems to be appropriate. A specific short option adjustment percentage will not be included in the rules.\11\ --------------------------------------------------------------------------- \11\ A schedule of the sliding scales that OCC intends to use initially is attached as Exhibit A to its filing, which is available for inspection at the Commission's Public Reference Room and through OCC. OCC will always specify a minimum short option adjustment percentage. OCC will inform its members of the initial schedule of the sliding scales through an Important Notice and will notify its members of any changes to the schedule. --------------------------------------------------------------------------- OCC believes that this information provides appropriate flexibility to make adjustments to the sliding scales from time to time as OCC determines is warranted. OCC further believes that the proposed rule change is consistent with the approach taken in Rule 60(c)(1)(C)(1) and Rule 602(c)(1)(ii)(C)(1) which both permit OCC to use such formulas, assumptions, and data as it deems appropriate for purposes of calculating additional margin. OCC believes that the proposed rule change is consistent with Section 17A of the Act \12\ and the rules and regulations thereunder because it furthers the public interest by reducing the overcollateralization of certain short positions in deep out of the money options. In addition, OCC believes that the proposed rule change should remove an impediment to market liquidity while still providing OCC with appropriate protection to the risks presented by short out of the money option positions. --------------------------------------------------------------------------- \12\ 15 U.S.C. 78q-1. --------------------------------------------------------------------------- B. Self-Regulatory Organization's Statement on Burden on Competition OCC does not believe that the proposed rule change would impose any burden on competition. C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants or Others Written comments were not and are not intended to be solicited with respect to the proposed rule change, and none have been received. III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action Within thirty-five days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to ninety days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or (ii) as to which OCC consents, the Commission will: (A) by order approve such proposed rule change or (B) institute proceedings to determine whether the proposed rule change should be disapproved. IV. Solicitation of Comments Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act. 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 Commission's Public Reference Section, 450 Fifth Street, N.W., Washington, D.C. 20549. Copies of such filing also will be available for inspection and coping at the principal office of OCC. All submissions should refer to File No. SR-OCC-98-11 and should be submitted by January 12, 1999. For the Commission by the Division of Market Regulation, pursuant to delegated authority.\13\ --------------------------------------------------------------------------- \13\ 17 CFR 200-30(a) (12). --------------------------------------------------------------------------- Margaret H. McFarland, Deputy Secretary. [FR Doc. 98-33911 Filed 12-22-98; 8:45 am] BILLING CODE 8010-01-M