Report of the Special Study of the Options Markets to the Securities and Exchange Commission

MISSING IMAGE

Material Information

Title:
Report of the Special Study of the Options Markets to the Securities and Exchange Commission
Physical Description:
xxxvi, 1084 p. : ill. ; 24 cm.
Language:
English
Creator:
United States -- Securities and Exchange Commission. -- Special Study of the Options Markets
United States -- Congress. -- House. -- Committee on Interstate and Foreign Commerce
Publisher:
U.S. Govt. Print. Off.
Place of Publication:
Washington
Publication Date:

Subjects

Subjects / Keywords:
Options (Finance)   ( lcsh )
Securities -- United States   ( lcsh )
Stock exchanges -- United States   ( lcsh )
Options (Finance) -- United States   ( lcsh )
Genre:
bibliography   ( marcgt )
federal government publication   ( marcgt )
non-fiction   ( marcgt )

Notes

Bibliography:
Includes bibliographical references.
General Note:
Reuse of record except for individual research requires license from LexisNexis Academic & Library Solutions.
General Note:
CIS Microfiche Accession Numbers: CIS 79 H502-22
General Note:
Reuse of record except for individual research requires license from Congressional Information Service, Inc.
General Note:
Dec. 22, 1978.
General Note:
At head of title: 96th Congress, 1st session. Committee print. Committee print, 96-IFC3.
General Note:
"Printed for the use of the House Committee on Interstate and Foreign Commerce."

Record Information

Source Institution:
University of Florida
Rights Management:
All applicable rights reserved by the source institution and holding location.
Resource Identifier:
aleph - 021633565
oclc - 04988638
lccn - 79602182
Classification:
lcc - KF49
ddc - 332.6/45
System ID:
AA00023995:00001

Table of Contents
    Front Cover
        Front Cover 1
        Front Cover 2
    Title Page
        Page i
        Page ii
    Letter of transmittal
        Page iii
        Page iv
    Digest of report
        Page v
        Page vi
        Page vii
        Page viii
        Page ix
        Page x
        Page xi
    The special study of the options markets staff list
        Page xii
        Page xiii
        Page xiv
    Glossary
        Page xv
        Page xvi
        Page xvii
        Page xviii
        Page xix
        Page xx
        Page xxi
        Page xxii
        Page xxiii
        Page xxiv
        Page xxv
        Page xxvi
    Table of Contents
        Page xxvii
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    Chapter I. Introduction
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    Chapter II. Fundamentals of exchange traded options
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    Chapter III. The use of options by professional traders
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    Chapter IV. Self-regulatory organization surveillance of the standardized options markets
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    Chapter V. Options selling practices
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    Chapter VI. Self-regulatory organization oversight of retail firms and their associated persons
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    Chapter VII. Financial regulation in the options markets
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    Chapter VIII. Issues of structure in the standardized option markets
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    Back Cover
        Back Cover 1
        Back Cover 2
Full Text





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96th Congress COMMITTEE PRINT Committee
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R. E P () R'l

OF THE


8111ECIAL STt7DY OF THE' rpci
OPTI MARINE T k7

TO THE

SECURITIES AN-D ("o11-VISSR'N


















Deceniber 22, 1978











Prhited for the of the House Coiiiinittee on hiterstatewid


U.14. GOVERNMENT PREN'l'IN1; (j,"'WE
4,, 1,40 WASHINGTON : 1 )79


For sale I)y t1w Superinten(iollt (d Dw-11111vilts, U.S. Prilltill- ()ffiot, Washinl-ton, DJ' 20-102
























COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE
HARLEY 0. STAGGERS, West Virginia, Chairman JOHN D). DINGELL. Michigan SAMUEL L. DEVINE, Ohio
LIONEL VAN DEERLIN, California JAMES T. BROYHILL North Carolina JOHN M. MURPHY, New York TIM LEE CARTER, Kentucky
DAVID E. SATTERFIELD III, Virginia CLARENCE J. BROWN, Ohio BOB ECKHARDT, Texas JAMES MI. COLLINS, Texas
RICHARDSON PREYER, North Carolina NORMAN F. LENT, New York JAMES H. SCHEUER, New York EI)WARD R. MADIGAN, Illinois
RICHARD L. OTTINGER. New York CARLOS J. MOORHEAD, California
HENRY A. WAXMAN, California MATTHEW J. RINALDO, New Jersey
TIMOTHY E. WIRTH. Colorado DAVE STOCKMAN, Michigan
PHILIP R. SHARP, Indiana MARC L. MARKS, Pennsylvania
JAMES J. FLORIO, New Jersey TOM CORCORAN, Illinois
ANTHONY TOBY MOFFETT, Connecticut GARY A. LEE, New York JII SANTINI, Nevada TOM LOEFFLER, Texas
ANDREW MAGUIRE, New Jersey WILLIAM E. DANNEMEYER, California
MARTY RUSSO, Illinois
EDWARD J. MARKEY, Massachusetts THOMAS A. LUKEN, Ohio DOUG WALGREN, Pennsylvania ALBERT GORE, JR., Tennessee BARBARA A. MIIKULSKI, Maryland RONALD M. MOTTL, Ohio PHIL GRANMM, Texas
AL SWIFT, Washington
MICKEY LELAND, Texas
RICHARD C. SHELBY, Alabama
W. E. WILLIAMSON, Chief Clerk and Staf Director KENNETH J. PAINTER, First Assistant Clerk ELEANOR A. DINKINS, Assisttint Clerk WILLIAM L. BURNS, Printing Editor

(II)










LETTER OF TRANSMITTAL


p N- .


i SECURITIES AND EXCHANGE COMMISSION
o zWASHINGTON, D.C. 20549
OFFICE OF
THE CHAIRMAN







February 15, 1979





The Honorable James Scheuer
U. S. House of Representatives
Washington, D. C. 20515 Dear Congressman Scheuer:


I am pleased to transmit herewith The

Report of the Commission's staff's Special

Study of the Options Markets.


Sincerely,







Hai~rd .M. Williams .CT.a irman


(III)



















Digitized by the Internet Archive
in 2013













http://archive.org/detaiIs/respecialsOOunit












SECURITIES AND EXCHANGE COMMISSION WASHINGTON. D.C. 20549

Special Study
of the
options Markets



December 22, 1978



To the Chairman
and Members of the Securities and Exchange Commission

It is an honor to transmit to the Comission the Peport of the
Special Study of the Options Markets. The Report describes the findims and recommendations of the Options Study in response to the
Comrission's directive set forth in its public release of October 1977. */
The Compission specifically directed the Options Study to investigate
and study the listed options markets to determine th ability of selfrequlatory organizations, including national securities exchanges and
the National Association of Securities Dealers, Inc., to carry out their
reulatorv responsibilities to assure that listed options trading is
occurrinq in a manner, and in an environment, which is consistent
with the maintenance of fair and orderly markets, the public interest, the protection of investors and the other objectives of the Securities
Exchange Act of 1934.

In general, the Ootions Study found that options can provide useful alternative investment strategies to those who understand the complexities and risks of options trading. But, since regulatory
inadeciuacies in the options markets have been found, the Options Study
is making specific recommendations needed to improve the regulatory fraTework within which listed options trading occurs and to increase
the protection of public customers.

The ep-ort is divided into eight chapters. The Introduction includes
a summary of the Options Study's conclusions and recommendations. Chapter II describes some fundcental uses of options. Chapter III describes the ways that market professionals use listed options. Chapter IV describes
and evaluates the market surveillance systems of the self-regulatory
orqanizations. Chaoter V discusses options selling practices. Chapter
VI analyzes the adeouacy of self-requlatory organization oversight
of broker-dealer firms. Chapter VII describes financial regulation
in the options markets. Chapter VIII discusses certain market structure
issues that orooosals to initiate new options trading programs have
raised.



*/ Securities Exchange Act Release \b. 14056 (October 17, 1977).


(V)







VI



While the best of the market surveillance techniques that have been developed would provide a self-regulatory organization with a general ability to detect known mrroper trading patterns, the Options Study found that numerous improvements must be made in this area to maximize the effectiveness of self-regulatory organization surveillance. First, the surveillance information available to each self-regulatory organization must be improved. In addition, surveillance information must be better shared among the self-regulatory organizations ard surveillance oroqrams should be better coordinated. Further, each self-reulatory organization must evaluate its own surveillance program to assure that it is using the most sophisticated market surveillance techniques available. New and additional data also need to be developed to relate options trading to underlying stock, trading not only for current market surveillance purposes, but also to study the patterns, relationships and effects of related stock
and options trading.

The Ootions Study found numerous instances of sales practices
abuses in which registered representatives told investors of possible rewards they miaht expect from options without simultaneously warning them of the risks inherent to options trading. Often, inadequately
trained registered representatives recommended options strategies to their customers which it is doubtful that the salesmen, much less their customers, understood. The most prevalent source of sales practice abuses appeared to occur in broker-dealer firms that encouraged or permitted their registered representatives to recommend options trades to their customers before the firms had in place appronriate suervisory controls to protect their public customers.

Although the primary responsibility for assuring that options participants are both informed and treated fairly rests with the brokerage firms, the self-reulatory organizations are required to see that these industry-wide standards are established and met by their member firms. Serious shortcomings were found in the selfrequlatorv organizations' oversight programs to detect and prevent selling practice -buses of their member firms. Representatives of the self-reaulatory organizations demonstrated to the Options Study staff their awareness of many of these regulatory problems and their willingness to seek solutions on a continuing basis. The options Study believes that its recommendations for improved internal controls by brokerage firms, enforced by self-regulatory organization rules and actively overseen by the Conmission will protect investors from many of the selling practices abuses currently found in the options markets, while at the same time fostering better understanding of the risks of options trading by public customers.






VII



The Options Study also found that in the area of oversight of
broker-dealer retail activities, as well as market surveillance, there was a need for greater cooperation and sharing of information among the self-reoulatory organizations to avoid present duplication of activities and to substantially improve the effectiveness of the combined regulatory efforts. In order to facilitate this cooperation, representatives of the self-requlatory organizations formed a SelfPeaulatorv Conference to consider ways in which to improve the coordination of their activities and to share market surveillance anc3 other regulatory data. To be successful, this effort will require the full cooperation of the self-requlatory organizations and the support and participation of the Commission.

In general, the recommendations of the Options Study call for action by the self-requlatory organizations to improve their own procedures and those of their member firms. Placing primary responsibility on the self-requlatory organizations reflects the Lortance of self-regulation in the regulatory oattern of the securities industry. If the selfrenulatory organizations do not act, the Options Study recommends that alternative action should be taken by the Commission through its authority over the self-requlatory organizations and through its own enforcement cower s.

For the most oart, the Octions Study has used examples of actual
abuses to demonstrate the problems which its recommendations are expected to correct. The Ootions Study has not generally mentioned firms or individuals by name, nor has any attempt been made to quantify the extent of the abuses. The qoal of the Options Study has been to recommend improvements where reulatorv lapses have permitted significant abuses to occur or where additional abuses could occur if corrections are not made. 'oile some recoamendations may increase costs to the self-regulatory organizations and broker-dealers, the Options Study _s made every effort to develop the least costly solutions and has sought means to reduce current duplicative regulatory efforts in some areas so as to offset increased efforts required in other areas.

Throughout its work, the Ctions Study has been aided by the cooperation of the self-regulatory organizations, the Securities Industry Association and broker-dealer firms. In many instances, the Options Study imposed substantial extra burdens on both organizations and individuals. Without the assistance of a number of individuals who made their expertise freely available, the Options Study could not have completed its task within the time period that the Coriission established. Except as otherwise noted, staff investigations were concluded by the end of August 1978, although an effort
has been made to take into consideration any subsequent improvements reported by the self-requlatory organizations.






VIII



In addition, during the period of the Options Study, a number of improvements were made in the regulatory programs of the selfreaulatorv organizations. Some of these improvements may have been coincidental with the Options Study's work. Others, however, may have reoresented an acceleration of improvements that would otherwise have occurred. Thouestionably, many improvements resulted from the increased attention given to finding solutions to deficiencies by both the securities industry and the Commission during the moratorium.

While much of the Report focuses on the deficiencies that were found in the regulation of the options markets, credit must be given to the self-regulatory organizations for the regulatory and surveillance work that they have accomplished since listed options trading began in 1973. Many recommendations of the Options Study are designed to extend to all self-regulatory organizations techniques which were develoned and are already employed by one or more of the selfreoulatorv organizations.

In view of the scope and complexity of the matters covered in the Report, the Options Study cannot be viewed as providing the definitive answers to all of the questions which need to be answered.J In accordance with the Commission's directive to concentrate on the regulatory aspects of the self-regulatory organizations, the/ Options Studv's recommendations are designed to be effective in the
options markets as they currently exist. Thus, in many respects, the Ontions Study is merely a beginning. Its efforts should be continued as a part of a regular Commission program of oversight of the options riearkets. Some of the Ootions Study's recommendations are designed to continue this effort by developing new sources of data so that the Commission and self-regulatory organizations can examine potential problems which the Options Study could not analyze because adequate, usable data was not available.

The Options Study did not undertake a study of certain broader issues. The Options Study, for example, did not undertake its own broad economic studies of the effect of options on the trading in the underlyirn stocks or on the capital raising functions of the securities markets, but instead has referred to studies performed by others. As the options market matures, and as additional information becomes available, further studies will be needed. The Options Study did not attempt to compare the specialist and competing marketmaking systems used by the options exchanges. Similarly, while the Options Study has made recommendations to imrxove the ability of those who make markets on the floor of an exchange to use credit in their marketmakinq activities on terms more favorable than public customers,







ix



it did not consider whether there should be changes in the present system~ of credit regulation which might make such favorable treatment unnecessary or inadvisable.

A concerted effort has been made to simplify the description of the matters covered in the Report and to avoid technical jargon and extensive references to rules and regulations and legal precedents. Unfortunately, the canplexity of the subject matter has prevented us from meeting this goal consistently. The pronoun 'he,' rather than other alternatives, has been employed throughout this Report to avoid the awkward reference 'he/she'.

While the staff of the Options Study is responsible for the Report's contents, it was aided greatly by other members of the Cornission' s staff. It drew upon the time and resources of the various Commrrission Divisions in Washington and upon all of the Corrmission's Regional Offices. Much information, along with ideas which form the core of the Options Study's recommendations, was developed froml these sources. A list of Commission staff personnel who contributed to the Options Study appears at the end of this letter under "Acknowledgments." Special mention, however, must be made concerning the extensive and continuing support of Andrew M. Klein, Sheldon Rappaport, and Kathryn B. Mc~Grath of the Division of Market Regulation, Stanley Sporkin, Wallace L. Tirrmeny, Theodore A. Levine andr Ira H. Pearce of the Division of Enforcemnent, and Ralph C. Ferrara and Robert C. Pozen of the Office of the General Counsel. The Options Study was organized and directed by Martin L. Budd until June 16, 1978, when he resigned as Director for personal reasons.

Re lly sutlmitted,



Richard L. l-berg
Director













THE SPECIAL STUDY OF THE Of TIONS MARKET TS

Director:

Richard L. Teberg
Martin L. Budd (before June 19, 1978) Chief Counsel: Martin Moskowitz Senior Economic Advisor: Gene L. Finn Assistant Director Self Regulatory Systems: Van P. Carter Assistant Director Sales Practices: Thomas J. Loughran Assistant Director Trading Practices: Kenneth S. Spirer Financial Regulation and Credit Specialist: Robert L. Smith Special Counsel: Richard I. Weingarten Special Assistant to the Director: Marianne K. Smythe Staff Attorneys:
Lawrence R. Bardfeld Sanvmy S. Knight
M. Blair Corkran, Jr. John E. Larouche
Ray J. Grzebleiski Gary G. Lynch
Richard G. Ketchum Janet R. Zimner

Senior Financial Analyst: Dennis G. Shea Economic Liaison (until June, 1978): Richard J. Morrisey Statistical Consultant: Fobert H. Menke Editorial Consultant: Lael Scott Staff Assistant: Rhoda S. Clavan Interns:
Brian Timken
Williami T.K. Dolan

Secretaries:
Denice S. Dishman Rosalie C. Moyer
Cletha I. Francis Lorna Olsen
Gall D. Hctjg Donna M. Phelps
Nora J. Huke Pai-ela M. Switzer
Valerie L. Krohn Sandra L. Washington
Susan E. morrow


(XI)







XII



ACKNOWLEDGMENTS

The Options Study received assistance from numerous segments of
the Ccmission's staff. Regretably, it is not feasible to acknowledge
the contribution of each person individually. A special note of
appreciation is given, however, to the staffs of the following offices
and divisions and to the particular individuals noted below:

Headquarters Staff

Directorate of Economic and Policy Research Division of Market Regulation

Roger W. Spencer Andrew M. Klein
Charles W. Bryson Sheldon Rappaport
Peter G. Martin Kathryn B. McGrath
Hajo Lamprecht Lloyd H. Feller
Johnathan L. Hunter Douglas S. Scarff
Eileen F. Whelan Mark 0. Fitterman
Roger D. Blanc
Division of Corporation Finance Nelson S. Kibler
Harry S. Day
Richard H. Rowe Harry Melamed
Mary E. T. Beach Michael P. Maloney
J. Rowland Cook Jessica Licker Osborn
Paul A. Belvin Robert J. Bretz
Timothy M. Harden Leonard L. Hunger
Gene E. Carasick
Herbert F. Brooks, Jr.
Therese M. Haberle
Division of Enforcement Marc L. Weinberg
Barbara E. Polonsky
Stanley Sporkin William J. Finegan
Theodore A. Levine
Edward D. Herlihy Office of the General Counsel
Ira H. Pearce
Richard V. Norell Ralph C. Ferrara
Paul W. Bodor Robert C. Pozen
Joseph Cella John P. Wheeler
Harold L. Halpern Eric D. Roiter
John F. Hart igan Theodore Bloch
Stanley B. Whitten
Office of Public Affairs
Office of Consumer Affairs
Andrew L. Rothman
Justin P. Klein
Office of the Secretary
Office of Data Processing
George A. Fitzsinmons
John D. Adkins Shirley E. Hollis
Richard T. Redfearn Charlene C. Derge
Raymond J. Kramer
Office of Administrative Services Office of the Executive Director Richard J. Kanyan
James T. Willis Benjamin Milk
George G. Kundahl
James A. Clarkson, III







XIII



Regional and Branch Offices

Atlanta Denver

Jule B. Greene Robert H. Davenport
George M. Callahan Harold M. Golz
John T. E. Van Deusen
Kenneth E. Newman Fort Worth

Michael J. Stewart
Boston Wayne M. Secore
Willis H. Riccio Gordon R. Cox
Arthur A.. Carr James H. Perry
Raymond D. Vaillancourt Mary Lou Felsman
Thomas P. Kehoe
Katherine W. Keane Los Angeles

Chicago Gerald E. Boltz
Hillel Cohn
William D. Goldsberry Israel Mattatia
William M. Hegan Raoul McDuff
Joan M. Fleming Joel M. Bolten
Ronald P. Kane
Michael J. O'Rourke *Miami
John R. Brissman
Ellen E. Douglass William Nortman
Steven D. Edelson Charles C. Harper
Diane Fischer Charles D. Hochmuth
Joyce Lynch
David M. Matteson Seattle
Peter B. Shaeffer
Jack H. Bookey
New York C. Arnold Taylor
John R. McNeall
William D. Moran
Edwin H. Nordlinger Washington
Sheldon G. Kanoff
Carmine L. Asselta Paul F. Leonard
Michael T. Gregg Edward A. Kwalwasser
Paul S. Maco Richard A. Mangini
Bernard Schwartz Robert W. Martinson
Louis A. Perrotto
*Philadelphia
*San Francisco
Thomas H. Monahan
Sheldon J. Sandler Leonard H. Rossen
Daniel F. McAuliffe Steven N. Mochtinger
John A. Galante Harry M. Jones
Ming Suen
Branch Office













GLOSSARY

It is hoped that the following brief explanations of various terms
and acronyms used in the Option Stud~y's report will be helpful, particularly to the non-grofessional reader, in understanding the text of the report. Of course, no attempt has been made here to formulate legal definitions.


Account Statements :Brokerage firm statements sent periodically to customers, usually itemizing all securities held in an account and the cash balance.

At-the-money :When the option's exercise price is the same
as the current trading price of the underlying stock.

AMEX Am~ierican Stock Exchange, Inc., on which stocks
and listed stock options are traded.

Arbitrage :Trading to take advantage of a perceived temporary
pricing disparity between two securities.

Audit Trail : The physical record of trading information identifying,
for example, the brokers participating in each transaction, the firms clearing the trade, the terms and time of the trade and, ultimately and when applicable, the customers involved.

Bearish :An investor's attitude when he believes the market
or a particular security's price will decline.

Bear Market :A market in which the general trend of securities
iices is down.

Bear Vertical
Soread :A hedged strategy employed when an investor expects
a decline in the secur ity pr ice but at the same time seeks to limit the potential loss if he is wrong. This spread requires the simultaneous purchase and sale of options of the same class and expiration date but different strike pricese.ci., if call options are "spread ," the purchased option must have a higher exercise price than the sold option (for a higher premium on the sale).

Beta .A measure of a stock's sensitivity to the movement
of the qeneral market.


(xv)







XVI



Bid/Ask The market quotation for a stock or option.
A bid is the price at which a potential buyer is willing to buy. An ask is the price at which a potential seller is willing to sell i.e., his asking price.

block Trade A single transaction involving a large number
of shares or option contracts. The NYSE defines a block as a transaction of 10,000 shares or
more.

Broker-Dealer A securities firm, generally one that does
business on behalf of custom( ers (as a broker) and for its own account (as a dealer).

Bullish An investor's attitude when he believes the
general market or a particular security's price will advance.

Bull Market A market in which the general trend of securities
prices is up.

Bull Vertical
Spread A hedged strategy used when an investor expects
that the price of a security will go up but at the same time seeks to limit his potential loss should his judgment be in error. This strategy involves the simultaneous purchase and sale of options of the same class and expiration date but different strike prices e.g., if call options are "spread," the purchased option must have a lower exercise price than the sold option.

butterfly Spread An options position involving the simultaneous purchase
and sale of options in the same class, with the same expiration date, so that for every two options sold, two options-one with a higher exercise price and one with a lower exercise price-are bought.

Call Option A contract giving the holder the right to
buy a specified number of shares (usually 100) of the underlying stock at a specified price within a specified period of time.







XVII



Called :Another term for "exercised" when the option
is a call. The writer of a call must deliver the indicated underlying stock when the option is exercised or called.

Capping :Effecting stock transactions shortly prior to an
options expiration date to depress or prevent



a rise in the price of a stock so that previously written call options will expire worthless and the premium received therefrom will be protected.

CBOE :Chicago Board Options Exchange.

Class of Options options contracts of the same type (put or call)
covering the same underlying security.

Clearing Firm A broker-dealer member of the Options Clearing
Corporation (C2C) engaged in the business of clearing, through CC, listed options transactions for its own account or on behalf of
other firms. Called a "marketmaker clearing firm" when it clears for marketinakers.

Closing Purchase :A transaction in which an option writer terminates his obligation by buying an option with the identical terms as the option previously sold.

Closing Sale A transaction in which the holder of an Option
liquidates his position by selling an option having the same terms as the option he previously purchased.

Carrissions :A fee charged each customer by his brokerage firm
for stock or options transactions made on his behalf.

Cauipliance Programs: Activities conducted by self-regulatory organizations
to detect and discipline violations of the Federal securities laws and securities industry rules concerning retail sales and certain other practices of their member firms and employees. Broker-dealers conduct similar programs respecting the activities of their own sales personnel.




























S-AO79>- 2







XVIII



Conversion An arbitrage technique involving buying an underlying
stock, selling the related calls and buying puts corresponding to the calls.

Cover A writer's purchase of stock to deliver to the holder
when the holder exercises a call option and the writer does not then own the stock he wrote the call on. Also, to purchase options to eliminate a short options position.

Delta Factor The amount of change in an option's theoretical value
relative to small changes in the price of the underlying stock over a short period.

Demand The degree of investor interest in purchasing a security.

Equity The net worth of an account, determined by subtracting
the market value of short security positions and the debit balance (if any) from the market value of long security positions and the credit balance (if any). Equity represents ownership in the account.

Equity Securities : Corporate securities, usually ccmMon stocks, which represent ownership in the issuing corporations.

Excessive Trading : Transactions that do not have a valid investment purpose but, instead, are made for the purpose of generating commissions for the salesman or brokerage firm. Often called "churning."

Exercise Price
(Striking Price) Tne price per share at which the option buyer may
buy, in the case of call, or sell, in the case of a put, 100 shares of the underlying stock.

Expiration Date The date on which an options contract expires. The
date is listed by monthonly (e.g. January, April, July) and refers to the Saturday following the third Friday of the month.

Fictitious Trades Reports of transactions submitted to a price reporting system of an exchange but which, in fact, did not occur.







XiX



Finn Proprietary
Trading Securities transactions entered into by a brokerdealer for its own account.

Frontrunning The practice of effecting an options transaction based
upon non-public information regarding an impendiny block transaction in the underlying stock, in order to obtain a profit when the options market adjusts to the price at which the block trades.

Haircut An amount deducted from a broker-dealer's net worth
in determining its net capital. It is a percentage of the value of a broker-dealer's marketable securities and is designed to provide a cushion of capital in the event of adverse price movement. The percentage amounts generally range from 1/8 of a percent for ccnmrical paper to 30 percent for common stock.

Hedging Lessening a risk of loss by, for example, offsetting
a long position in one security with a short position in a related security, or vice-versa.

Holder Person who purchases an option, also called a buyer.

In-the-Money : When the exercise price for a call is lower than the
current market price of its underlying stock; or for a put, when the exercise price is higher than the stock's current market price.

Initial Margin : A deposit a customer must make in accordance with
Regulation T as a result of a securities transaction. Naked call writers, for instance, must deposit cash or margin securities whose loan value equals at least 30% of the value of the underlying securities, less the proceeds of the option sale.

Institutional
Investors An investment company, bank, insurance company,
endowment, pension fund or other organization which has substantial funds committed to securities investments.

Intrinsic Value The amount by which the current market price of the
(of an option) underlying stock exceeds the exercise price of a call
option, or is less than the exercise price of a put.







xx



Listed Option An option traded on a national securities exchange.

Lo~ng Option
Position .The number of option contracts of a particular
option series held in an individual account or group of accounts.

Maintenance Margin The minimum amount of margin (equity) that must be maintained in a general account as required by exchange or association rules.

iMarketiiker A dealer who holds himself out as being willing
to buy and sell securities for his own account on a regular or continuous basis. on the options exchanges, certain rules are designed to require such market participation for members dealing on their floors, and such members may be called competit ive marketmakers, registered options
traders, etc. See "Specialist" below.

Mini-manipulation An attempt to influence, over a relatively small
range, the price movement in a stock to benefit a previously established-options position.

MSE :Midwest Stock Exchange.

NASD .National Association of Securities Dealers, Inc.,
a self-regulatory organization of broker-dealer members involved in the over-the-counter securities
markets.

Naked (Uncovered)
Option Writing An option writing position collateralized by cash
or by securities unrelated to those on which the stock option is written.

Near Term :Close to expiration.

NYSE .New York Stock Exchange, on which most of the stocks
underlying listed options are traded.

OCC OpCtions Clearing Corporation.







XXI



OCC Prospectus The required disclosure document for listed options.
Exchange rules require that a current prospectus be provided to options customers at or prior to the time their accounts are approved foroptions trading.

Open Interest The number of listed options contracts of a class
outstanding at any given time.

opening Purchase
Transaction A transaction in which an investor becomes
the holder of an option.

Opening Sale
Transaction A transaction in which an investor becomes
obligated as the writer of an option.

Option A contract which allows the buyer, by exercise,
to buy or sell stock (usually in 100-share units) at a certain price (exercise or striking price) over a certain period of time, regardless of how high or low the price of the stock (the underlying security) moves during that time.

Options (OTC) Non-listed put and call options whose expiration dates
and exercise prices are not standardized; OFPC options are not cleared or guaranteed by the Options Clearing Corporation (OCC).

Out-of-theMoney When the exercise price for a call is higher
than the current market price of the underlying stock or, for puts, when the exercise price is lower than the stock's price.


Parity When the premium (market value) of an option at
least e-iials its intrinsic value.

Pegging Eft, Aock transactions to prevent a decline
in t rice of the stock so that previously written put opt ns will expire worthless, thus protecting premiums previously received.







XXII



Pertormance
Written materials used by sales personnel to present to options customers the results of actual options transactions, usually in the form of a profit and loss statement.

PHLX The stock exchange headquartered in Philadelphia
on which stocks and listed options are traded.

Position
Adjust-iients Charges initiated by clearing member firms in their
customer, market maker or firm proprietary options position records maintained by OCC.

Position Limits Limits set upon the number of options contracts
relating to an underlying security which an investor may own or control.

Prearranged Trades Transactions on the floor of an exchange which are effected pursuant to a prior agreement among the parties. An order to buy or sell an option is entered with the knowledge that another person will enter an order of substantially the same size, at substantially the same time, and at substantially the same price. Two variations are called "wash sales" and "trade reversals."

Premium The money paid for an option contract by a buyer
and received by the option's writer. The premium is kept by the writer whether or not the option is exercised.
Professional
Traders Persons who earn their livelihood from buying
and selling securities on the floor of an exchange, such as an institutional money manager, or a dealer trading from off-floor, etc.

PSL Pacific Stock Exchange. Listed options are traded
on the San Francisco floor of this exchange.

Public Customers Persons who pay commissions to effect securities
transactions through broker-deaiers, and who are not professional traders.







XXI



Put ("ation :A contract giving the purchaser the right to sell
a specified number of shares (usually 100) of the underlying stock at a specified price within a specified period of time.

Req iste red
Representative A salesperson employed by a brokerage firm who
handles customer accounts.

Regulation T The Federal Reserve Board rule goenn, among
other things, the amount of credit (if any) that initially may be extended by a broker to his customer on a securities transaction.

Restricted Ontions :An options series in which prohibitions on opening purchase and sale transactions are in effect.

Reverse Conversion :An arbitrage technique involving the short sale of an underlying stock, the purchase of related calls and the sale of puts corresponding to the calls.

Registered Options :An employee of a broker-dealer firm who is Principal ("POP") responsible for supervising the customer
options account activities. He is required to pass a special qualifying examination in options.

Scalping An option marketmaking strategy involving the
purchase of options at the bid price and sale at the asked price in order to earn the differential or spread, sometimes referred to as the "jobber's turn".

Secondary Mar ket Provides for the selling and/or buying of
previously bought or sold options through closing transactions.

Self -Penulator y
Conference A series of meetings commenced in August, 1978,
attended by representatives of the self-regulatory
organizations to discuss issues raised by the Motions Study.







XXIV



Series : options of the same class having the same
exercise price and expiration date.

Short Option
Position : The open position of the writer or seller of an
option.

Short Term Of limited duration. All listed option trading is
generally referred to as short term because options expire in a maximum of nine months.

SIAC Securities Industry Automation Corp. An organization
jointly owned by the American Stock Exchange and the New York Stock Exchange that acts as facilities manager and data processor for various securities related activities of the SRO's.

SIPC Securities Investor Protection Corp. A non-profit
membership corporation established by Congress to afford certain protection against financial loss to customers of its members which fail. Its members, with certain exceptions, are all registered brokers or dealers.

Specialist A member of a specialist exchange (e.g., Amex, NYSE),
as distinguished from a marketmaker exchange, who is permitted to deal on the exchange floor for his own account while at the same time effecting transactions as broker for the accounts of others. For some purposes, however, marketmakers are sometimes referred to as specialists.

Ali specialists have certain obligations to maintain fair and orderly markets. Among the benefits they enjoy by virtue of their specialist status is special margin treatment under the Federal Reserve Board Regulations T and U.

Spread The difference between one price and another (for
example, between the bid and the ask prices); or an options position created by buying and selling of different series of options of the sainee class.

SR0 Self-regulatory organization-includes the national
securities exchanges and the National Association of Securities Dealers (NASD). Each is required to regulate and oversee its broker-deaier member firms and their employees.







xxv



Straddle :A combination option position consisting of one
put and one call1 of the same class. Either option is exercisable or salable separately and tne exercise prices and expiration dates are usually identical.

Striking Price :Also called exercise price. The price at which
an option is exercisable.

Suitability :Suitability is a concept designed to protect
customers by obligating brokerage firms and registered representatives to reccuixend for a customer only those securities transactions wh ich
they reasonably believe are not unsuitable forie customer in light of his financial situation and needs.


Surveillance : h rme rthods by which the self-regulatory organizations
Programs detect trading practices that
may be inconsistent with the Securities Exchange Act, the rules thereunder, and the rules of those organizations.

Transactions Costs :Expenses incurred in buying or selling securities, the most important of which are commriss ions.


Uncovered (Naked) :A writer who does not own the underlying stock Writer which is thie suoject of an option.

Underlying Stock The stock subject to being bought or sold upon
exercise of an option.

Upstairs Dealer
Firms .Securities dealers that initiate exchange transact ions from off the floor of the exchange.

Wrksheets, Written materials used by sales personnel to
portray to customers the potential profits and risks of proposed options transactions.

Writer .The seller of an option contract.












CONTENTS


rage
Letter of transmittal------------------------------------------------III
Digest of report---------------------------------------. V
The special study of the options markets staff list xi
Glossary- --------- xv

CHAPTER I-Introduction:
A. The growth of listed options trading ---------------------------- 1
B. Effect or listed options trading on the securities industry - -.... 9 C. Studies of economic effects of listed options trading -------------- 12
1). Summary and conclusions of the options study- ................18
1. Self-regulatory organization systems- ---------------------19
(a) Market surveillance -------------------------- 19
(1) American Stock Exchange surveillance information and audit trail 21
(2) New York Stock Exchange surveillance information and audit trail--24
(3) Firm proprietary and customer trading information-- 25
(4) Options clearing corporation position adjustments- --------------------------26
(5) The sharing of surveillance information and the allocation of regulatory responsibility- ....................... 27
(6) Investigation and enforcement---------- 30
(b) Broker-dealer oversight-....................... 33
2. Trading practices_-37
(a) Professional trading-----------------------------38
(b) Position limits_-40
(c) Clarification of trading rules .................... 42
3. Selling practices_-43
(a) Customer protection-44
(1) The OCC prospectus -------------------44
(2) Customer suitability------------------ 47
(3) Opening account statements------------ 50
(b) Responsibilities of broker-dealer firms -- ----------52
(1) Qualification of registered representatives- 52
(2) Supervision of registered representatives and of customer accounts -------------54
(3) Recordkeeping and communications with customers--56
(4) Exercise allocations------------ 38
4. Financial structure ---------------------------------- 58
(a) The Commission's net capital rule ----.-59
(1) Increase of deductions in computing net capital------------------------------.60
(2) Net capital deductions for marketmaker clearing business-----------------. 62
(3) Marketmaker minimum net capital ----- 63
(4) Financial requirements of upstairs dealer firms-----------------------------... -64
(5) Marketmakers that are OCC members.__ 66
(b) Options specialist stock credit 67
(1) Stock hedge----------------... 68
(2) Limit on stock qualifying for specialist stock credit-----------------........-71
5. Market structure-72 (xxvII)






XXVIII

C(11APTER II --Fundiamentals of Exchange Tritled Options: Page
Page
A. characteristicss of options ......73
1. Conventional OTC options compared to listed options .- 73 2. The options contract .76 3. Stock price (consi(lerations in listed (options 82
4. Short-term character of options trading ...83 ;5. Transaction costs ---------------87
ti. Options pricing models ----. ..90
7. Examples of the effect of options contracts ---- 96
(a) Call option -97
(1h) Put option . . . . . . . . . 99
(c) Gains or losses tc options buyers are offset by losses or gains to options sellers . . . . 102 B. Principal strategies . . . . . . . . . . 106
1. Introduction . . . .. . . . . . . 106
2. Ten l'asic strategies ------------ ----- 107
3. Survey of investor use of option strategies --------------- 114
4. Writing options for premiums ..------------ -----------117
Exhibit 1: The relationship between puts, calls, starddles and
stocks ... .. . . . .121

CHAPTER III-The Use of Options By Professional Traders:
Introduction- .... .... ....... .... .... .... ... ...125
1. On floor market participants 129
(a) Obligations -------------------- 129
(b) Privileges 132
(c) Options trading strategies 135
(d) Stock/options trading strategies 138
2. Upstairs firms 144
(a) Advantages enjoyed by upstairs firms ------------------ 144
(b) Arbitrage trading ------------------147
(1) Conversion and reverse conversion arb)itrage 148
(a) Conversion arbitrage -----------149
(b) Reverse conversion arbitrage ....... 151
(2) Hedged short selling .......153
(3) Merger or exchange offer arbitrage------------- 155
(4) Discount options arbitrage-------------------- 158
c. Block trading _159 d. Creation of synthetic puts 163
3. Institutional investors ... . . .165 4. Specific trading abuses -------------------169
(a) Fictitious trades 169
(h) Prearranged trading 170
(c) Chumming ---------------171
(d) Stock option manipulation -- ---- 173
(1) Minimanipulation -------- 173
(2) Capping and pegging ---------- 175
(3) Statutory prohibition of manipulation---------- 176
(4) Problems of proof and the need for data 178
(e) Front-running ------_---. 183
5. Trading rules _----_-----_-----_-----------189
(a) Position limit rules ------------------ 189
(b) Restricted options rules . . . . . .. . 193






XXIX

CHAPTER IV-Self-Itegulatory )rganizatin Surn illanw c of the Stanldardize(I Options Markets: Page
Page
I. Introduction . .. .. ... .. ... .. ... . 197
II. Methodology ---- -..201
III. Surveillance infoi imation 2............ ... 03
1. The sources of surveillance inforinal ion 203
2. The organization of capture of su veillance inforillation_. 208
( a) Transaction information 208
t h) Clearing information .212
(c) Account information- ... .......214
3. Conclusions and reconmendation 219
a. Surveillance infoi mation--------- 219
(1) AMEX surveillance information and audit trail ---------------220
(2) N YSE surveillance information an audit trail ----------223
(3) Stock market reconstruction---- 230
(4) Firm proprietary and custonmel trading identification ---------233
(3) Custonmei account identification . 236
(6) OCC position adjustments ------ 238
b. Surveillance techniques .. . . . . . 243
(1) Surveillance techniques and surveillance information_ ---243
(2) The sharing of surveillance information and the allocation of regulatory responsibility -----------------------244
(3) Improving options exchange surveillance techniques ------------------- 252
(4) Uniform Iepoiting requirements....-_ 253 IV. Investigation and enfoIcement ---------------254
1. The CBOE and PSE 255
2. The PHLX ----------------------------------------257
3. The AMEX-------------------- 258
4. The MSE ..263 Table 1-Surveillance data Available _207 Table 2-Compaiison of surveillance data available to surveillance data
captured ---------_-_-_218

Exhibits:
1. CBOE Market Data Retrieval Listing (MDR):
A. By Time --------------------------------------------265
B. By Price -------------------------------------------- 266
2. Amex options daily journal report 267
3. NYSE daily transaction journal ......269 4. CBOE matched transaction listing (MTL) --------------------- 270
5. NYSE daily reconciliation clearing sheets ........... 271
6. OCC daily position report_ 273
7. Amex foim 958-C_ 274
8. PSE form OTR-1 -------------------------------------------275
9. Letter to Richard Teberg, Director, Special Study of the Options
Markets, from the Self-Regulatory Conference, dated October 6,
1978 -------------------------------------------------------276






XXX

Appendix Exhibits*:
1. Trading procedures and trade matching operations of the AMEX,
CBOE, MSE, PH LX, PSE, and N YSE; surveillance techniques
of the AMEX, CBOE, MSE, PHILX, and PSE.
2. Sample inspection (outline and inspection information request
(C13OE).
3. CBOE marketmiaker minimanipulation and capping investigation (Case No. M 7145).
4. PSE expiration study.
5. C('BOE capping investigation (complaint No. M 8018).
(i. AM EX capping investigation.
7. AMEX capping investigation.
8. N YSE expiration study.
9. CBOE prearranged trad(ling investigation (complaint No. M 8080).
10. AMEX prearranged trading investigation.
11. CBOE prearranged trading investigation (Case No. M 7052).
12. C(BOE fictitious trading investigation (Case No. M 7061).
13. CBOE front-running investigation (Complaint No. M 8078).
14. AMEX front-running investigation.
15. PSE front-running investigation.
16. Insi(de information investigation.
17. AMEX inside information investigation.
18. CBOE position adjustment investigation (complaint No. M 8098).
19. CBOE position adjustment investigation (complaint No. M 7163).
20. Table A: Exchange surveillance parameters.
Table B: Summary of exchange personnel.
Table C: Exchange surveillance expenditures.
Table I): Optio ns exchange cleared contract volume.

CHIAPTEIR V-Options Selling Practices: Page
Introduction _-----------_-----_--_--_--_--_--_-----_--_-----289
A. Registered representative qualification, preparation and motivation-_ _-_-_-_-_-_296
B. Supervision of counts --------------------314
C. Suitability _-----_ -._____336 1). IDisclosure documents ---------------------369
F. Promoting options-general problems --------------384
F. Promoting options--specific methods ------- --402
(. Promoting options-investment programs ........... 425
I. Options trading in customer accounts --------------440
I. Exercise problems --------------_--_--------. _477

CIIHAPTER VI-Self-Regulatory Organization Oversight of Retail Firms
and Their Associated Persons:
I. In trod u ction _.._ .._. ._.._. .. ...._. ._. ._.._. ._.._. 48 7
II. An Overview of SRO compliance programs .......... 492
A. M onitoring programs . . . . . . . . 492
1. Employment and termination of registered representatives- - . .....493 2. Customer complaints 494
3. A advertising .. .. ....._. ..._..._.. 494
4. Financial responsibility early warning systeis ... 496 5. Credit monitoring .496 B. (ause examinations 497
('. HIoutine examinations ----- 498
1). )isciplinary actions- __501

*These Appendix Exhibits are availa e pulliely in the omission'sns Putli Reference Room and, therefore are not pu lished us a part of this report.






XXXI

CHAPTER VI-'1',)ntinu(--l
'Page
111. OI)tainingeonil)liaiieeinf(,)i-inlltl()11--A.
B. 507
1. 507
2. Coordination of compl I I*0 prognallis ------ 5 1 C,
C. Government agencies- -) I IS
1). Retail
1. Accessibility of custoiner complaints and account
2. Reportitigi-equireiii( i-its---.--------IV. Wficienci(- iii SRO examinationsA. Limitel scope of (-\aminat ions
B*. Poor ;ele(:G)n ()f ar(,oiints for reviewC. Inadequate depth )f account eviiiiinationsD. Reliance on firms for
E. Fai I tire to resol ve dispi-itt, I is-- u, Of f ac 7
F Ina(lecluate
V. Remedial
A. F-Ixtent of disciplinary
B. U- Of informal sanctions ------C. for inadequate

D. SRO internal 51 l
E. as a
F. TV(,) lisciplinary- pro(-(-,, fimat ri(-)t,,
VI. The for mininium SRO ci,)mi)111,L1lC(,o' 5117
Tal-)Ile I-'-Number if optlom z related sale practice or eapit:1' j-) ra c t i c e
e x a i n i n a t i o ri s c o-) n o- I i-i c t ( I - R Os 500
Table II-Summary (if SRO examination anif disciplinary i i-) n to
fii-illxyz----Tab] e I I I-Su in m ary of S R 0 inf ormat ion On sel eet ed securities sal esm en 12 Table IV-: electecl cornj)ari. on of complaints reportect to an(l
complaints received t hy tw,) -' 'SE meinher firms- ill 197 7 -5 2 5
Table V-:-4inlmarv of typt- of options relate(l (J(q( ot" :. INSROs in their -1977 sales i)raet1c(-,- and CtpitaV- a',- 1)-actice 'I
tions of firms -with options commissimi in(,in(-iri ex(-ess Of 539
Table VI-Options related sales prwtice di.- (-iplinarN actions hrwigh+ I)y
theSROsa-m of 'March 5 53
Table VII-Summary of disciplinary action 1)y an SRO again, t firin AB('--- 555

Exhibits:
Option, tu(ly que-tionnain, t to the option., exchang--, App. A/).
Option ; ;tivly qii,--4ionnain -itt to th, -NYSE (App. B*).
Option, study ii to the -NASD ( A 1) 1). C*I
SUT1111larv of SRO options rcl:ited examination, ancl inv(--;tigatio-)n,-; ()f
firm OEF foi, 1973-1978 (App. D) ---------------------------- 570
L to Rich Tt I )-rg fi-0111 th SAf- It y1-1L-ttOr i- ( 'If- I ('Tl(-'- Aj)j).
E) -)77
L-tt"r fl-0111 Van P. Caft ,r u ("Wrald Folev J-)Ct. Ill 197i )
App. fl)
Summary of -Itati- ties relating to SRO routin- practice -, exammat i o-) n ( App. I
S11111111'arv Of S RO financial r ,-;wirce-z (App. 11)

!1 the Col .:..
fore, are ii,-, a part of






XXXII

(CIIAPTER VIIt-Financial Regiiulation in the Options Mai kets: age
:Page
I ntroduction -.- - - - - - - - 615
Bioker-dealer financial regulation- 620
1. The Securities Investor Protection Act .620 2. Conmission tin ..(121
(a) Conmmi-sion's customer protection rule (121
(b) Commission'. uniform net capital rule -( 622
3. The Options Clearing Corporation financial rules --------625
(a) 0(CC clearing nienhers -.......... 625
(b) O CC mneIlber capital requirements_ ...... 628 (c) Commission's net capital requirements .------ 630
(d) OCC settlement requirements ------ 632 (e) OCC clearing fund ...639
4. Study of the financial integrity of the options markets 640
(a) Margin and clearing fund deposits- 643
(b) Market makers and market maker clearing firms -. 646
5. Reconlmnended change- to the net capital rule ... 649
(a) Concentrated positions _. .. . ..... . 649
(h) Short positions in near or at-the-money options- 6532 (c) Restriction on volume of business carr (Ie --------- 655 (d) Market maker minimum net capital ----- 657
(e) OCC members and their affiliates that are market
makers ----------------------------- 66 1
(f) Immediate charges to carrying firm under the net
capital rule -___ -____-_ 663
(g) Conversion--reverse conversion positions ...... 665 (h) Financial requirements of upstairs dealer firms ------ 667
Options specialist and stock credit ------- 0'--- -674
1. Specialist accounts ------------------- 676
2. Good faith credit --------- ......_.. 678
3. FIree-riding and hona fide hedging ---------- -680
4. Options pricing formula_ ____ _____684 5. Limit on stock qualifing for specialist stock credit- ..... 691

Exhibits:
1. SEC reporting forms X-17A-5 part II and part IIA -------693 2. Options study letter to OCC, dated May 5, 1978 and attachment 695
3. Options study letters to AMEX, BSE, CBOE, MSE, NASI),
NYSE, PIfLX, and PSE, dated June 7, June 16, and June 27,
1978 and attachments_ 705
4. Options study financial and operational questionnaire:
(a) Form A _---- _---------_----_--- 763
()) Form B ----------------------768
5. Options floor participant equity:
(a) All options exchanges ----------------769
(b) AMEX _---------_---------_--- 770
(c) CBOE----------------- 771
( ) M SE . .. .. . .772
(e) PSE _77 3 (f) PILX 774
G. UOp)tions floor particpiant equity requirements ... 775
7. Letter from the staff of the Federal Reserve Board, dated I)ecemher 5, 1978 _. _.._.._ 776

CII APTER VIII---Isues of Structure in the St an rdiz(le( Opt ion Markets:
1. Introduction .... .- -. 779
II. The statiltrv stamd .ard 782
A. A niiatiional market system ..782 1. A national Iarket -syst(iL and SE( aiullhority 782 2. Ohjective- of a natioiial market sysvtemi .. .. 786
3. The ('liuilnation of mn ctssaryl' regii:1torv 1(tricti ms ... 7t90
*4. (Coilmunic:ntion amol1g aind 0isse1ni1:1111 of information about securities markets. 792
5. M\iltiple rndling ....- 795
B. The basic statltory goals -..-. 797






XX XIII

CHAP~TER{ VLL-C1 )ritiniued Page
III. Multij)L traf hug of stan lar~lizd o1t100~
A. Th, efcts of multipyh t rat I ig of :,tan, ,, Iw li/,.v t i I I
1. iI7Iv effects of intltip.l r hgo t'(iii of markets for mtult iply tI ~i jtiel-- I)
2. Couip, it ion among i1 k-t, c rit S 24
B. Market t frge8iin-----------------27
1. Th- extenit of market fragmntitt u f,,: :Ii iltiplv traded option a-e--------2. Brokerage fit in, orderi routing l ~l~ int h fragininte I niarket environineitw3 :3. i\Iarket fragnfint at n n, o pt ion pricingz, :tild ()rfV interaction----C. ('uicluion'-------------- S4
1. The' multiple trading of -tandardize(I optiol- it hi the Exchange' Act-- -2. TPhe mnultiple trIad ing experleni-ii
3. 'Iarkct f ragnientatioti and t the, Exchange Act ~ 1
4. Primary market h1,signatioi:- and Iaut omlat( i

5. The m-ultiple t reading of :-t am laBtize : ,pt ioll- andI recent initiative> toward the 10-%( lp)iIli~t of a

IV. The integrate ion of tra(iing of options and( their un I u ling

A. The gene al coflsi(Ieuations- 7 t -"7i
1. The( (ijility of makt------,----~77
2. The re-gulatory cocrn--------a}i 'Mark~et inform at ion and I jpoet iIve ad(b) 'Manipulation and other imprope(,r t ra( Iing p'it~5------( C) Potential conflicts in market making ()I,3. The extent of integration--------- 0
4. Charactei istic.- of the exchange-------- 93
(a) Prim ary an([I secondlarv exchange -------904
(b) The m aiketmnakin g >vt~---------907 B. Conclus ions----------------------------------------- 911")
1. The gradual Ipoah-------------916
2. Principles of: general atpplicabilitv and the St atutory st ad----------------917
3. The, principle>- applied--------------920
V. An ox-el-the-counte r market for standardized opin----- 926v
A. Standardized option>- and underling ,(,curitie-- tradeet
exclusi-vely, in the over-the-counter niarketAs-------930
1. The abs-ence of real-timne last -;ah reporting for underlying --ecurities tradled exclusively in the over-the-counter maret,) 3 ----;3
2. Repre, entative bid and ask quotations for -ecurities tradled in the over-the-couniteri miarket- 93B. Trading exchange listed options in the ove r-the-counter
markets-----------------------945
1. I'r-agmentation and inenlzto--------946
2. 'Market information andI competitive adlvantages; of over-the-counter marketnmakers--------------4,S
3. Over-the-counter mac~rkets and a- national market syv,-tern -which wvouldl include standardized options-----------------------951
C. The integration of t rading of opti-i ,ri am, T tEir Pn ,,e1dvin g
seCurities in the over-the-couinter make52
1. 'Market information, competitive advantage anl~ imrprojier trading 95f;e'-------- )
2. 'Marketmaking obligat ion,. am I Cohuflit iheli t1

.3. Marke-t urv(,illance in the ovor~-t h,,-- ur

makt-------------------





XXXIV

CHAPTER VIII-Continued
Page
1). ()nclusions 972
1. Real-time last sale reporting and rIepresentative bid and ask (1utatiOn-- 972
2. An over-the-counter market for options raled on exhanges._ 976
3. The integration of trading of options an their underlying securities in the over-the-counter market>~ --- 980
VI. The New York Stock Exchange and[ standarlized options
trading ----- e- 983
A. The predominant position of the New York Stock Exchange in the market> for underIving securities 987 1. N YS E market share 987
2. N YS V financial resour ces 988
3. N YSE market making resources 990
4. Additional N TSE resource 991
B. Potential NYSE predoininance of the standalized optiois m-arket 994
1. N YSE land the primary mar ket d eignatioi- 994 2. N YSE facilities ad vantage 995
3. N YSE advantage with respect to conhined rdr996
4. N YSE financial resources- 997
5. N YSES marketmaking resources and advantages 999 6. N YSE ability to attract talent- 1005
C. Conclusions -_ -_--- --_-_-_-_-_- 1007
1. The predominant position of the New York Stock Exchange--------------- 1007
2. The New York Stock Exchange and the statutory dilemma--1014 3. A cautious approach _ _- 1021
VII. A national market system for standardized options- 1028
A. Options and the evolving national market system 1028 B. Options and the objectives of a national market system 1030 C. The form of a national market system 1035
1. A comprehensive quotation system 1036
2. Market linkage and order routing systeins 1044 3. Nationwide limit order protection--- 1046
4. Off-board trading restrictions 1049
Taile 1- -Call option classes which have been listed on two or more options
exchanges- 1051
Table 2- Sumnmary of price continuity data for call options inultiply
traded on CBOE and AMEX 1052
Tubhle 3-Suilinary 1bid/ask sprea(I data for call options multiply traded
en the C(BOE and AMEX-1053 Tal Be 4-Total contract volume for call options listed on h)th AMEX
and CBOE 1054
Ta1lde 5-- Sunimarv price continuity data for call options multiply traded
eI 1both a primary nld secondary exchange -----105 Tal e ---Sumnmary hid/ask spread data for call options multiply traded
m both a primary and Secondary exchange- 1056
Table 7A- Weeklv average variation in price per transaction for 1)uPont
C(lp. cal options oii AMEX for the three months prior to and following
iitiatioln of multiple trading 1057
Table 7H--WNeekly average variation in price per transaction for 1)uPont
Corp. (ll options on (1BOE for the three months following initiation
of multiple trading_ _-_-_-. 1058
Table SA-Weekly average hi/ask spread for )ulon t Corp. call options
on AMEX for the three imionths preir to and following initiation of
miiultiple trading _ u 109
Table SH- W(kly average bid/ask spread for )uPont Corp. all options
On ('1HOE( for the three iontihs following initiation of nmult iple trading 1060 Talb)le 9A- Weekly average variation in price per transaction for Merrill
Lyich call options on AMEX for the three months prior to and follcwiig initiation of IlniltiIle trualing 1061





xxxv

Tahle OB-Weekly 1A.Verag(I Val iation ill pric(' p"r for
Lynch call options oil ("BOE f0i, the three inonth, ; f-'*,k li i:iltittlon 'I age of multiple trading______ 62
Table IOA-W( ( kly average bid/a-k spr(,ad for M(.i-rill Lynch call
on AMEX for the 3 months prior to the f(, )Ilowing initiation of niull lit) ',
trading__Table IOB-NV(,(,klv av( rage bidlask sprea(I foi- Merilll Lynch (-t" j)T 1, 11on CBOE for the 3 nionth- following initiation of multipl(' Tahle IIA-Sunimary pricf, c(,minulty an(I bid/ask prcad
()T-gaIIlz(,([ hy ,ize of option premium fol. Dupont Corlwration 1065
Table 1IB-Suininary price continuity an(I hid/ask illf,,-t,_ ioil
oi,,nanized bv size of option preillitilli froin Bui ri)uffh- Corpm,,il ill 1 7 Tahle ]IC--Suminary piic(, continuity aiid kj,'
organize (I hy Aze of option pi,(,miuni foi, Digl, il E(plip1m,11T '')()raTable 12-Exchange market zhai-(, in option 4 li,-;t(,(i oil I)oth a, pi-imii y and,
;(,condai,,,_ exchange foi, :-;(,lfcte(t dav., z fi-om Feloruaiv 24, 1977 thj-()jl1ylI
August 31, 1977_______Table 13-Exchange mai-k(4 hai e in option 11- t(.(l (on CBOL' MI(I AMLX
fol. Selected dav from Fehruarv 24, 1977 through Augu-t 31, P)77--_ 72
Table 14-Exchange T -hare in opti(,ii- -which wer(, multiply ti,,td(,,I
foi elected davs fiont 1,'ehruai-v 24, P)77 through August 31, 1977--- 1 7: Tahle 15-Contiaci, volume an(t mark("t :.Iar( of thf, CBOE and AME X
for August 1978 1 74
Table IG-GBOE monthly contract volume and mai ket '- har( f(_-)I Al-11(-1,1011)"
Expr(,, Blally Mfg., Digit'al, EAjujpm(,nt an(I 'National
from 1/1/78 to 10,'31 10717)
T1-11)1(, 17A-CBOE mark( t A-lare ill national 1076
Table 17 B- CB 0 E m a i k (1 t S ha i n (I i g i t It I i 1) ill t 77
Tahle 17C-CB01] niark(-t ,hare ill B, ily 107,
Tahle 17 D- CBOE rnaiIet .. hare ill Americlail Exj ) 1079
Taile PS-Comparkon of Bdly Mfg. opening pr1cf- u A'-\IEX infl ('B(-)I"
Sel)tenll IT 1, 197 S_ 1 0
Tahle 19-T--0 optiori revenue for (,condary (,xchang(,- an(I
of total r,\change
Tal)le 20-T-tal optlon- net incon-if- foi (,xch,,tiig(,-: ar
centage of total exchange net
Table 21-Tot,-tl r(,venuo-- derived f--in ()I)tl()Il t1* 11-1 -LICtiOTI ch, ,,- ()n
secondai-y exchange , and p(-rc(,iitag(, of total option.-z I
Table 22-("BOE' Talle A: 'N Y,' E in,-irket hai (, 1 2
Table 2:3-('BOI,' Tal)le B: Di, zvihution of riiai-k(,t ill cel't"U11 C011,111)()II
stock,-- anct (Iigihlo f,), (,xch,-tng(, option t ra, lingTahle 24-('BOE Table C: crupaiative financial lnf(,-)imati(.n foi, dolhii-)_ I 0,'_ 4

Appendix Exhibits
1. Letter to George A. Fit z -.;immon m(t Exchange C0111frr"I'll janies K Buck, ;(,eretarv, N_-(,Nv York ',- ,toek Ex(,,h,,iig,, Septeml)er 22, 197-,- an(t Letter to A.
Fit z Seej'etal'- 'Securiti(-z and Exchan(TO Comn,).,-.in,
from J.tnii,.- E'. Buck, secretary New Yol k tock
date(t -Nov(-inker 291 197 .
2. Letter to Gworge A. FItzslnlnl()E Z. and ENchan,(, fioin J--ph W. Siil pre; id(,,nt,
Chicigco Boar(I Opti,)n; date(l t_-r 22, 197S'.
3. Lotei, to George A. Fitz-iiliinon ('cu-itie- alld I-,%change Cc)11-111i m,; ioill f-,,,?ii EIkIIII.; p-e'vielit" Pl,;,.Idelphia .- tiwk Exchaiig, tatod 2 _), 197S.
4. Letter to A. Fitz -imlllw)-;, aIIJ
change fiviii Ch J. l1,,ii,,.v,
,tock Ex .,jnge., (iat(,(l 'Sc, 1) t 2 2,
5. L(,ttet, to ,,re-re A. Yltz.; in-mj()jj,, Xchanp, Gmmiszsion, from Biri,
Ain(,rican Stock Exchange, 21.1, 197S.

*TheSP v






XXXVI

Appendix Exhibits: Continued
i. Letter to George A. Fitzsimmons, Secretary, Securities and Exchange Commission, from Gordon S. Macklin, president, National Association of Securities Dealers, dated September 22,
1978.
7. Letter to 1icha,(d I. Weingarten, special counsel, Special Study
of the Options Markets, from Joseph W. Sullivan, president,
Chicago Board Options Exchange, dated October 11, 1978.
S. Pacific Stock Exchange Study comparing Pacific Stock Exchange
and Chicago Board Options Exchange markets in Houston Oil and Minerals Corporation and Teledyne Corporation (luring
December, 1976.











INTRODUCTION

Listed options are caiplex securities. bTo those wno understand

now tney worK, tney iiay otter an alternative to snort term stock trading at lower coulnission costs ana a smaller colTitinenrt of capital. They also provide a ieans tor snitting the risk or unfavorable short term stocK price movements trom owners of stocK wno have, out do not wisn to uear, those risks,' to otners who are willing to assume sucn risks in anticipation or possioLe rewards fran tavoracle price nmovenments.

but, cotn tne purchasing and writing (selling) of options involve a nign aejree or tnanclai risK. Only investors wno unaerstana those risKs, ana wno are aoble to sustain the costs and financial losses coat may ue associated with options trading snoula participate in tnle -istea options marKets. Too otten, public investors have Oeen encourage to use isteu options without regard to the suitaoility or options tor tneir investment needs.



A. 'he Grown or Listed Options Trading


T'he volukie of trading in listed options has grown substantially since t'eoruary, 1973 when tne Caunission authorized the Chicago Board Options Excnanye ("CLoD") to inaugurate sucn trading as a pilot program. 1/ 1/ securities Lxcnange Act eiease No. 9985 (February 1, 1973).


(1)






2



The CBCE's ilot program, designed to "test the market" for listed

or*ions, was initially limited to call options on only 16 underlying

stocks. As listed options gained in popularity, the options markets

expanded sharply over the next four years:

-The number of exchanges trading options
grew, from one, in 1973, to five in 1977
(see Figure 1).

--By mid-1977 the number of stocks on which
call options were traded had increased
from 16 to 219, and put options had been
added for 25 of those stocks causing a sure in open interest and volume (see
Figure 2) .

-The volume of listed options trades, measured
by the number of shares receivable on exercise
of an options contract, expanded from the
equivalent of 2.6 percent to the NYSE's total
share volume in 1973 to almost 75 percent
of that volume during the first six months
of 1978 (see Fiqure 3).

-Premiums paid for options contracts increased
in the aggqregate from .3 percent of the dollar
value of shares traded on the bbw York Stock
Exchange ("NYSE") in 1973 to 8.2 percent during the first six months of 1978 (see
Figure 4).

The addition of new optionable stocks to those already traded was one

element in the rapid expansion of listed options volume. However,

an examination of volume trends for CBOE listed calls (excluding those

also traded on other exchanges) based on when each class was introduc~ed, as shown in Figure 5, indicates that the opportunity to rapidly exvand volume by adding new listings, while extremely important in the early






3


Figure 1

21HE EXC-ANr,.ES N WHICH LISTED OPTIONS ARE CFFERED


Trading in listed calls began on the: April 1973 : Chicago Board Options Exchange

January 1975 : American Stock Exchange

June 1975 Philadelphia Stock Exchange

April 1976 : Pacific Stock Exchange

December 1976 : Midwest Stock Exchange June 1977 Trading in listed puts began on all exchanges
which traded listed calls.






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years of options exchange development, has now substantially diminished for call options. The options exchanges themselves had an incentive to list those issues which they thought would have consistently high trading activity. The statistics show that even if no additional classes had bDeen listed after 1973, trading volume on the CBOE by the end of 1977 would have expanded about eight fold over 1973's total as compared to the 16 fold growth recorded when the trading volume for the classes listed after 1973 is included. Vben the volume in multiply listed call options and puts is also included, 1977 trading volume is shown to be 22 times cqreater than volume in 1973. The criteria established by the portions exchanges, and approved by the Coimmission, for stock selection were desiqned to assure that options were written only on issues of larqe, well capitalized firms with a large number of shares outstanding and substantial volume of activity. The remaining pool of eligible underlying stocks on which call options classes could profitably be introduced under the listing standards of the options exchanges appears to be increasingly

limited.

The addition of puts to all underlying stocks on which calls are currently traded could be expected to increase total options volume sigInificantly. Here again, however, the historical record does not suqgest that volume growth from this puts trading should be as dramatic as the volume qrowth was in the call market, in particular, because




9


"syvnthetic" puts are now being created to substitute for listed put options. 2/ Moreover, o~ut options were never as popular as call options in the over-thecounter ("OI'C") options market, rarely capturing 40 pe rcent of the total options volume of OTIC options and more often accounting for between one-fouirth and one-third of such volume.



B. Effect of Listed Options Tradinq on the Securities Industry


The qrowth of listed options trading has resulted in a substantial increase in options-related commission revenues earned by broker-dealer firms. Stanford Research Institute has estimated that commissions on listed options received by Nbw York Stock Exchange ("NYSE") members more than tripled from 1973 to 1974, increasing from $12 million to $45 million. 3/ In 1975, when registered broker-dealer firms first reported their options commission revenue separately from other commission revenues in their reports to the Commission, 853 registered broker-dealers reported receiving $257 million in options commissions. By 1976, listed options commissions received by broker-dealers had increased to $367 million, accounting for about ten rercent of total commission revenues related to the securities 2/ See infra, Chapter III.

3/ SRI International, Chapter T1an, "Options," excerpted from, Outlook for the U.S. Securities Industry 1981, P. 13.






10



business. The first year-to-year decline in options commission revenues occurred in 1977 when those revenues fell by about 13 percent to $319 million.

The imrmrtance of listed options commissions to broker-dealers has varied qreatly amorg firms as shown in Figure 6. For example, of the 1039 firms reortinq options commission income in 1977, fourteen firms received over fifty percent of the industry's total listed options conmnissions and 78 percent of total listed options commissions were received by 51 firms. On the other hand, over 75 percent of the members of the brokerage community received less than $100,000 in listed options commissions and 40 percent of the 1039 firms received less than $10,000

from this source.

Besides earninq direct commission revenues from options transactions, broker-lealer firms also earned significant revenues from "ootions-related" agency transactions. These transactions occur when a customer acquires or sells stock in connection with an options strategy, as, for example, when a customer sells stock short to write a covered out. Firms do not separately report the amount of optionsrelated agency business they do, and, accordingly, the amount of

revenues they earn is not known.

In addition to the agency business done by broker-dealers, a substantial number of firms and individuals engage in marketmaking activities










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on the floors of the options exchanges. In 1977, 1153 dealers engaged in such activities. As is the case concerning broker-dealer firms

doinq an aqency business, the financial benefits of options marketmaking activities have not been evenly enjoyed among marketmaking firms.

Amor the 1153 specialist/marketmakers, 122 reported profits of $l00,00 or more from options trading in 1977, receiving over two-thirds of the aaareqate $54 million in gross marketmaking profits reported by the marketmakers whose activities were profitable. On the other hand, aoqregate losses of $15.9 million were reported by 413 specialist/ marketmakers and, as shown in Figure 7, 89 percent of all specialist/ marketmakers either reported losses or showed profits of less than $100,000.


C. Studies of Economic Effects of Listed Options Trading


The most comprehensive review of the effect of options trading on

the underlying stock is the Robert R. Nathan Associates Inc. study concerning the first nine months of trading on the CBOE. This study was updated by the CBOE in July 1975 and again in February 1976. 4/ The study concluded that options trading had little discernible effect on: 4/ Review of Initial Trading Experience at the Chicago Board Options
Exchange, prepared for Chicago Board Options Exchange by Robert R.
Nathan Associates Inc., Washington, D. C., December 1974;

(footnote continued on next page)






13


FIGURE 7

BROKER-DEALERS REPORTING GAINS (LOSSES) FROM MARKETT
MAKING IN OPTIONS ON A NATIONAL SECURITIES EXCHANGE: 1977 ($ In Thousands)


Number Gains, (Losses)

Firms With Losses 413 ($15,935)

Firms With Gains of:
Less than $10,000 188 733

$ 10,000 $24,999 150 2,502

$ 25,000 $49,999 157 5,80

$ 50,000 $99,999 123 8,547

$ 100,000 $249,999 84 13,268

$ 250,000 $499,999 26 9,280

$ 500,000 $999,999 9 5,706

$1, 000,000 and over 3 8,176

Total 1,153 38,078


































40-40 >- 7- 4






14


1) The liquidity or operational efficiency of the stock market;

2) Volume of trading relative to NYSE volume; or

3) Price changes or orice performance relative to the NYSE
market as a whole.

The Nlathan studv also concluded that:

1) Exercise of options during expiration week had no systematic
effect on the daily price behavior of the underlying stock;

2) No regular or consistent pattern could be found between the
daily open interest for expiring options exercisable below
or at the current stock price (in-the-money or at-themoney options) and the price movements of the underlying
stoc ks;

3) The average closing bid/ask spreads of options stocks was
somewhat narrower than the spreads of a sample of other
stocks; and

4) The volatility of the price of the sixteen underlying stocks
on which options trading first started was less after options
trading bean.

More recent studies, however, have concluded that there are important

interactions between options prices and stock prices around expiration

dates. The price effects observed are generally smaller in size than


(footnote continued)

Analysis of Volume and Price Patterns in Stocks Underlying
CBOE Ootions from December 30, 1974 to April 30, 1975, Chicago Board options Exchange, July 1975; Analysis of Volume and Price
Patterns in Stocks Underlyinq CBOE Otions from December 31, 1975
to January 16, 1976, Chicago Board Options Exchange, February 1976.






15


the transaction costs paid by the public, 5/ possibly because of the effects of professional arbitrage. In addition, CBOE volatility data for 1977 and a recent independent study of volatility 6/ indicate that

the decline in the volatility of CBOE stocks relative to the market in 1974 was due to cyclical market movements, not options trading. In 1977, the relative volatility in the market for stocks underlying CBOF options was not much different from what it was at the beginning of the 1970's.

Other analyses have attempted to determine the economic significance of listed options trading on the raising of capital by business. For example, a study %s sponsored by the CBOE to assess the impact of listed options on the market for new issues of common stocks of small companies. That CBOE study developed statistics on the

overlaooinm involvement of investors in options and new issues of


5/ See Kooprasch, Robert W., "The Impact of CBOE Option Exercises U5on The Prices of the Underlying Common Shares," Ph. D. thesis,
Rensselaer Polytechnic Institute, Troy, bw York, April 1977,
and Klemkosky, Robert C., "The Impct of Option Expirations on Stock Prices," Journal of Finanical and Quantitative Analysis,
September, 1978, 'p. 514-517. Kopprasch points out that analysis of the effect of expiration activity on stock prices is severely handicapped by the absence of published uncovered position data. 6/ Naidu, G.N. "The Effect of Option Trading on Variability of Common Stock 1*turns," Presented at the Annual Meeting of the Southern Finance Association, 1977. Naidu finds evidence of
increased relative volatility of CBOE stocks in the postCBOE per iod.










Studies of the economic efficiency of options trading have been undertaken which conclude that listed options trading has resulted in increased transaction efficiency of the options market. These studies are based upon the fact that a put can be converted into a call and vice versa and on the presumption that a parity should exist between nut and call premiums if the market is efficient. Systematic deviations from parity of put and call prices provide opportunities for professionals to take hedged positions which are profitable and indicate market inefficiencies.

Fbllowinq ur earlier work by Gould and Galai in OTC

options 10/ Klemkosky and Resnick examined data on the securities for which both puts and calls were available in the listed market. 11/ Gould and Galai found persistent large variations in relative out-call prices in conventional options. Klemkosky and


10/ Relyinq on the principle of put and call parity, Gould and Galai
analyzed 159 pairs of closely matched options from the transactions recorded by an options broker. They found that the parity
model is frequently violated in that there were many instances
in which riskless conversion activities could have been profitably
undertaken. Diverqences from theoretical expected values were larqe, even larger than transactions costs. Gould, J. P. and
Galai, D., "Transactions Costs and the Relationship Between Put
and Call Prices," Journal of Financial Economics, July 1974,
po. 106, 117, 112.

i/ Klemkosky, Robert C. and Resnick, Bruce G., "Put-Call Parity
and Market Efficiency" presented to Southern Finance Association
Annual Conference, November 1978, Washington, D. C., pp. 21-22.










small companies and other ccxparative information on the opinions, attitudes and activities of investors. Among the conclusions of the CBOE study are the following:

1) The frequently expressed belief that exchange
trading of options has caused a negative impact
on the market for small new issues is based on
conjecture, mostly of an uninformed nature.

2) There was no siqnificant evidence that exchange
trading; of options has had a negative effect
on the market for small new issues. 7/

In the CT3OE study, 40 percent of options buyers who invested in both options and new issues claimed that the availability of listed options was one of the reasons for reduced purchases of new issues. These investors also indicated that if listed options were not available, the percentage of their portfolio typically going to small, new equity issues would rise from 1.3 percent to 1.7 percent. 8/ This CBOE study concentrated on the impact of options trading as opposed to the ultimate effects of options transactions. TIhere has been no study of the secondary effects on the flow of funds between the options market and other investments. 9/


7/ Robbins, Sydney V" ~ ugh, Robert E., Sterling, Francis L.
and Howe, Thomnas Impact of Exchange-Traded Options
on the Market for 1I,, ues of Common Stock of Small Companies, Ma ajentAalyss r, Cambridge, Massachusetts, June 1977,
TX.3-4.

8/ Robbins, et al p. A-12.

9/ As noted earlier, commissions on options transactions amounted to about $367 million in 1976 and $319 million in 1977.








Resnick found a lower incidence of such divergences in the listed

aut-call market.



D. Surmnarv and Conclusions of the Options Study


The raid qrowth in options volume and the appearance of abuses

resulted fi the Commission initiating an investigation and study of

the standardized listed options markets on october 17, 1977. The

Commission stated its concern about:

(1) the present ability of the self-rer-ulatory
oraizations' surveillance systems to detect
and prevent fraudulent, deceptive, and manipulative
activity, both in options and in underlying securities, in a manner which is consistent with the
maintenance of fair and orderly markets and the protection of investors and that canplies with
the recuirements of the [Securities Exchange]
Act; (2) the &deauacy of existing Commnission and
self-regulatory organization rules to prevent
fraudulent, deceptive and manipulative acts,
Practices, devices and contrivances in connection
with options trading; (3) the development of the standardized options markets in a manner which is consistent with the public interest in perfection of the mechanisms of a national market system for
securities and prevention of securities trading which adversely affects the financing of trade,
industry and transportation in interstate commerce;
and (4) the development of appropriate standards, formulated with reference to the purposes of the Act, by ukiich to measure the appropriateness of particular programs which would have the effect of expanding or altering existing pilot options
trading programs. 12/


12/ Securities Exchanae Act Release No. 14056 (Ocitober 17, 1977)
("(Lb tober Release") pp. 3-4.





19



As a direct result of these concerns, the Special Study of the Options Markets ("Options Study") was established to determine whether standardized options trading is occurring in a manner and in an environment which is consistent with fair and orderly markets, the public interest, the protection of investors, and other objectives

of the [Securities Exchange] Act, and to ascertain what, if any, additional action is necessary and proper to aid in the enforcement of the provisions of the Act and the rules thereunder to protect investors and to insure fair dealing in the trading of standardized

options and their underlying securities.

The Options Study has addressed many of the concerns expressed

by the Comission in the October Release. The findings and conclusions of the Options Study will be discussed in detail in the various chapters to this report. The Cotions Study's principal conclusions and the

steps that the Options Study recornends the brokerage community, the self-requlatory organizations, and the Cormission should take to improve the regulatory framework for the listed options markets to assure that these markets are fair and orderly are sunarized below.


1. Self-Regulatory Organization Systems


a. Market Surveillance

Market surveillance is the process of detecting trading practices

that may be inconsistent with Securities Exchange Act of 1934 ("Exchange






20


Act"), the rules and regulations thereunder, and the rules of selfrequlatorv organizations. Self-regulatory organizations engage in surveillance activities because, among other reasons, the Exchange Act assigns them responsibility, subject to Commission oversight,

for assuring that their markets are fair, honest, and orderly and that their members comply with the federal securities laws.

An effective market surveillance system must be able to produce

essential trading information quickly and accurately. It must be able to identify the brokers participating in each trade, the firms clearing

the trade, the time that the trade occurred, the price to which the Parties have agreed, the number of shares or contracts bought and solld, and wfiether the trade was executed for a customer, firm, or marketmaker account. Ultimately, the system must be able to identify, where appropriate, the customer that effected a transaction. In addition, the system must be able to identify bids, offers, and orders that

voere present in the trading crowd to obtain a complete picture of the trading environment at a particular time. To the extent

that this information is readily available, the ease of performing surveillance functions and designing surveillance programs is increased.

A surveillance system must also provide its user with a physical

record of the trading and other market activity that the system monitors. Such a record, often referred to as an audit trail, is necessary to verify the information that the system produces. Tn particular, documentary evidence






21


must be maintained either in or by the system if potentially improper trading practices are to be successfully investigated and resolved.

The Options Study reviewed the techniques that the self-regulatory orqanizations have developed to detect manipulative conduct involving related stock and options trading, manipulative conduct that may be effected using only options, misuse of nonpublic information in connection with options trading, and violations of the position and exercise limit and restricted option rules. This review included inspections of the options exchanges and the NYSE and an examination of their investigative and enforcement files. TIhe Options Study

found that while the best of the techniques that have been developed would provide a self-requlatory organization with a general ability to detect such trading practices, improvements must be made to maximize the effectiveness of self-regulatory organization market surveillance.

1) Ainerican Stock Exchange Surveillance Information and Audit Trail

Each of the exchanges that permits the trading of standardized

options has scene ability to identify the parties, reporting time, and terms of trades that take place on their trading floor. In addition, each of these exchanges has sane ability to obtain a physical record of those trades. The extent of these abilities, hover, varies significantly.






22



The CBOE, Pacific Stock Exchange ("PSE"), Mid1west Stock Exchange

("MSE"), and Philadelph~ia Stock Exchange ("PHLX") can identify the buying and selling brokers, the firms that will clear the trade, the time that the transaction was entered into the price reporting system, the price,, the number of contracts for each trade, and whether the trade was reported as executed for a customer, firm or market maker account. This informnation is available on an automated basis the day after the trades occur. It is customarily obtained from order tickets or transaction rerortinq slips that these exchanges collect when trades are executed aid is key ounched into exchange computers from the trading floor. The order and transaction reporting tickets are kept in case they are needed for surveillance purposes at some later date.

The American Stock Exchange ("AMEX"), on the other hard, does not maintain as complete a record of each options trade that occurs on its floor. As a result, it cannot verify trade information by using its own records. Moreover, the AMEX cannot identify, on a regular,, automated basis, the brokers that execute each options trade or the firms that will clear the trade. Consequently,, the AMEX must resort to the slow and costly process of manually reconstructing trading from specialist and registered option trader ("uR") reports and from order tickets obtained fromi member firms to detect and investigate questionable trading practices that may take place on its floor. The need to use manual processes to reconstruct options trading






23



makes this reconstruction at best costly and time consuming, and at worst impossible, for the AMEX to perform many of the surveillance procedures that other options exchanges perform routinely.

The AMEX has recognized that its surveillance system does not routinely provide information that is essential to an effective detection program. It has also recognized that a computer could

perform more efficiently and more completely many of the functions that the exchange now performs manually. As a result, the AMEX has undertaken to improve the surveillance information that the exchange regularly obtains. Smcifically, the AMEX intends to establish systems that would allow the exchange to identify the parties, terms, and reortinq time for each trade, and would provide a physical record, or "audit trail," of the trade for investigation and verification Durnoses. The exchange has represented that it will seek to implement this system during the first quarter of 1979, and began a "rilot test" of this new system on October 2, 1978.

Accordinly, the Ootions Study recommends:

THE AMEX SHOULD ESTABLISH A COMPLETE AUDIT TRAIL FOR EACH OPTIONS TRANSACTION THAT TAKES PLACE CN
THE AMEX FLOOR IN ACCORDANCE WITH THE SCHEDULE
THAT THE EXCHANGE PRESENTED. THE COM4MISSION
SHOULD REQUIRE THAT THE AMEX SUBMIT A COMPLETE
REPORT ON THE RESULTS OF ITS "PILOT TEST' AS SOON AS THEY ARE AVAILABLE. THE DIVISION OF MARKET REGULATION SHOULD FOLLOW THE PROGRESS
OF 1HE AMEX CLOSELY TO ASSURE THAT THE EXCHANGE
ENHANCES THE CAPABILITIES OF ITS SURVEILLANCE SYSTEMS AND ESTABLISHES A PROPER AUDIT TRAIL
AS QUICKLY AS POSSIBLE.






24



2) New York Stock Exchanqe Surveillance Information
and Audit Trail

The NYSE does not have the ability to identify, on a routine,

automated basis, the participants in each stock trade on its floor. Nor does the NYSE maintain a record, collected at the time that orders are executed, which indicates the parties, the reporting time, and the terms of each NYSE stock trade. While the Options Study has not examined or analyzed the NYSE stock surveillance system as a whole, the lack of such essential surveillance information raises a substantial concern regarding whether the exchange has the ability to fulfill its statutory responsibilities on a daily basis for each stock that is traded on the NYSE floor, including those on which options are traded. Moreover, despite the NYSE's recent initiation of a multimillion dollar tradingq facilities upgrade project," the exchange has not yet committed itself to obtain regularly the surveillance information that it lacks. 13/

A-cordinqly, the Options Study recommends:

THE COMMISSION SHOULD CONDUCT A COMPLETE INSPECTION OF THE NYSE MARKET SURVEILLANCE SYSTEM TO DETER4INE
WHETHER THE EXCHANGE HAS THE ABILITY TO CARRY OUT THE PURPOSES OF THE ACT AND TO COMPLY, AND ENFORCE COMPLIANCE BY ITS MEMBERS, WITH THE ACT, THE RULES
AND REGULATIONS THEREUNDER, AND NYSE RULES.


13/ Letter to Harold M. Williams, Chairman, Securities and Exchange
Comission, from William M. Batten, Chairman, New York Stock
Exchanqe, dated October 16, 1978.






25



SPECIFICALLY, THE INSPECTION SHOULD CONSIDER
WHETHER THE NYSE CAN DETECT, CN A DAILY BASIS AND
FOR EACH STOCK TRADED ON THE NYSE, TRADING PRACTICES THAT MAY BE INCONSISTENT WITH THE
ACT, THE RULES AND REGULATIONS THEREUNDER, OR
EXCHANGE RULES. THE INSPECTION SHOULD BE
CONDUCTED AND CCIPLETED AS EXPEDITIOUSLY AS
POSSIBLE AND A COMILETE REPORT SHOULD BE
PRESENTED TO THE COMMISSION WITHIN SIXTY DAYS
JFTER THE COMPLETION OF THE REVIEW.


IN THE EVENT THAT THE INSPECTION REVEALS THAT
THE NYSE CANNOT FULFILL ITS STATUTORY RESPONSIBILITIES ON A DAILY BASIS, THE COMMISSION SHOULD
TAKE APPROPRIATE REMEDIAL ACTION AND SHOULD
SPECIFICALLY CONSIDER REQUIRING, BY COMMISSION
RULE, THAT THE EXCHANGE COLLECT AND MAINTAIN
ESSENTIAL SURVEILLANCE INFORMATION WITH REGARD
TO EACH NYSE TRADE.


3) Firm Proprietary and Customer Trading Information

Certain surveillance information that is essential to effective

market surveillance is not readily available to any self-regulatory

organization. Specifically, the stock clearing process does not

distinguish between firm proprietary and customer stock positions,

and the identity of customers who effect stock or options trades cannot

be determined using surveillance information that is easily accessible

to the self-regulatory organizations. Self-regulatory organizations

must seek this information from the firms that entered the orders on

behalf of the customers. As a result, investigations into firm

oroprietary stock trading, and into customer trading generally,






26



r--, jlre frequent, costly and timie-consLz-ninq correspondence between 'r-yarlizations and their ri er f rms for the purpose of tne accc)unts involved in trading activity.

Securities Inoustry Automation Corporation ("SIAC"), n, t iate studies to determine tne cost and f easibli ity

4:
-ir7,, proprietary and customer trading, and of cistcx-iier acwunt identification inforTtiation in the stock c Learn process. Tney nave represented that these studies wiii be

3i, 1979. 14/
iccorc inqiy, t --e Opt ons Study recoi-turiends:

SHOULD Ri :VIE N T.iE SIAC PORT PROPRILTARY
IT IS COMPLLTL-J. L L)f



T

IT Y
1': L

I I S -'E THArL Do SC


I "; TO ST TDY
-7
"-G AI D OPTION
,- ,-7C"ERS 01 RCUTH :E, AUICMAr.=. :3ASIS. THE
COMMISSION SHOULD REVIEW TTiE NYSE SIAC REPORT 7j7S 11' SHCUID -L1ETE3v1:,N7- THE STEPS
771AT SHCL7,D 77E MKEN TIC ES'73=H A -NIFORM
A C=Yr I:E.'-1FICATION IN LIGHT OF THE REPORT.


4) 0.,ptions 'Clearini (--or,,)oration Position Adju. tents

-ot4ons v nas fojrd -nat i-nfor-ation currently

'r--- ')ctiors '-Iearinq Corpor;ation ("CCC") 7av be inadequate

,n S Dosil (on ---t- -rocess. adjustments

3CC,,r71is1, im.zToce r )urco se s szzuc! i -;:;s trade reversals,

n r 7,, s ac t 4, ns tv customers or fir7rs in restricted actions, and

Lc criorit,,7 .-,.;'Les for li,7,it orders and off-floor

--Y4 no. 3ut cle ar i nr 4:J,7,s s,, rit posJtion adjustments to the


r






27


OCC for several legitimate reasons: Tb correct errors and omissions that may occur when the terms and parties to an options trade are entered into the comaiuters of the firms for clearing purposes; to transfer accounts between two clearing firms; or to adjust records when one clearing firm executes and comamres trades for another firm on an options exchange of which the second firm is not a mecer.

The OCC has' undertaken to improve the surveillance information that is available with respect to position adjustments. By the end of the first quarter of 1979, the CCC will separately identify and distinuish all position adjustments involving transfers of accounts and adjustments that occur because a firm is not a member of the exChange on which a transaction that the firm cleared was effected. The CCC will also prohibit adjustments between clearing firms and will code and identify certain types of adjustments. The Options Study believes that these changes will substantially reduce the potential for abusing the adjustment process and will improve the ability of the selfreculatorv organizations to monitor adjustments.

Accordinqlv, the Otions Study recommends:

THE OCC SHOtULD IMPLENE ITS PROPOSED REVISIONS IN THE POSITION ADJUSTM1ENT PROCESS AS SCHEDULED.
THE OCC SHOULD ALSO STUDY THE FEASIBILITY OF FURTHER
REDUCING THE NUMBER OF POSITION ADJUSTMENTS BY
REQUIRING ITS MEMBERS TO RECONCILE THEIR ACCOUNT S
TO OCC RECORDS C A DAILY BASIS AND BY IMFOSING
A SURCHARGE ON FIRMS THAT SUBaIT AN EXCESSIVE NUMBER OF ADJUST4ETS. THE RESULTS OF SUCH A
STUDY SHOULD 3E SUBMITTD TO THE DIVISION OF
MARKET REGULATION WIHIN NIETLY DAYS.

5) The Sharing of Surveillance Information and the Allocation of Requlatory Responsibility

The OQtions Study observed a need for greater coordination of self-reaulatorv surveillance aroarams and for the sharing of surveillance information. The Options Study has discussed these matters with the selif-requlatory organizations with a view toward establishing a "more coherent and rational regulatory structure" for market surveillance. 15/ Durinq August and September 1978, 15/ S. Per. .b. 94-75, 94th Conn., 1st Sess. 2 (1975).





28



representatives of the options exchanges, the NYSE, the National Association of Securities Dealers ("NASD"), the OCC, and the Boston Stock Exchanqe (collectively the "Self-Regulatory Conference" or the "Conference") met to discuss the

need for the creation of an integrated
regulatory system among the [self-regulatory
organizations] which would enhance total
industry regulatory capability by coordinating
and interfacing existing regulatory data and
programs through the sharing of available
information, improvement of regulatory
techniques, [and] the allocation of regulatory responsibility. . 16/

The members of the Conference "acknowledge that the establishment of a more fully integrated regulatory system is both necessary and desirable as a means of establishinq more efficient and effective regulation which may be cost-effective to the industry and achieve minimum standards of regulation on an industry wide basis thus assuring the protection of public investors." 17/

During their working sessions, the members of the Self-Regulatory Conference identified all market surveillance reports and information presently available and reached a "consensus that the sharing of data


16/ Letter to Richard Thberq, Director, Special Study of the 0*tions
Markets, from the Self-Regulatory Conference, dated October 6,
1978, at o. 2.

17/ Id., at P. 3.







29



is both needed and desired." 18/ They specified the surveillance

information that they would like to receive from each other on a routine, automated basis and agreed generally to share all surveillance informration. In addition, they agreed to consider principles for allocating surveillance responsibilities among themselves and agreed to continue their meetinas to implement their information sharing plans and "to allocate additional responsibilities with respect to matters arising from inter-market regulatory problems and to further eliminate regulatory duplication." 19/ Theyv also invited the Commission to send a representative to future meetings. The Options Study believes that implementation of the initiatives that the Conference has taken is necessary to assure that self-requlatory surveillance programs are maximally effective.

Accord inqly, the Options Study recommends:

MHE COMMISSION SHOULD CLOSELY MONITOR TIHE EFFORTS
OF' THE SELF-REGULATORY ORGANIZATIONS TO SHARE SURVEILLANCE INFORMATION AND COORDINATE SELFREGULATORY ACTIVITIES. THE COMMAISS ION SHOULD
ACK~NOWL1EDGE BY LETTER THE FORMATION OF THE
CONFERENCE AND SUGGEST THAT THE LEE OF SECTION
17(d)(2) OF' THE ACT AND RULE 17d-2 THEREUNDER
TO ALLOCATE SURVEILLANCE RESPONSIBILITIES AMONG THE SELF-REGULATORY ORGANIZATIONS IS APPROPRIATE
AND DESIRABLE. IN ADDITION,, THE COMMISS ION SHOULD
SEND A REPRESENTATIVE TO FLTrURE MEETINGS OF TE CONFERENCE. THE COMMlISSION SHOULD ALSO SEEK TO COORDINATE ITS OWN SURVEILLANCE OPERATIONS W ITH
THOSE OF THE SELF-REGULATORY ORGANIZATIONS.


18/ Id., at p. 4.

19/ Id., at 'o. 12.







30


6) Investigation and Enforcement


The detection of trading that may be inconsistent with the federal securities laws cannot, however, be the end of surveillance. When such trading is detected, it must be investigated to determine whether the Exchange Act or self-regulatory organization rules have been violated. Moreover, where violative conduct is found, the federal securities laws and self-requlatory organization rules must be enforced and the conduct sanctioned with a view toward punishing the violator and deterring future violations. The Options Study's inspections of the options exchanges revealed significant differences in the thoroughness and effectiveness of their investigation and enforcement programs.

Generally, CBOE and PSE investigations were complete and adequately documented. At the Pq1.X, on the other hand, the extent of investigatory and enforcement efforts was difficult to evaluate because much of the investigatory process was informal and undocumented.

Accordinqlv, the Options Study recommends:

THE PHLX SHOULD PROVIDE COMPLETE DOCUMENTATION
WITH RESPECT TO ROUTINE SURVEILLANCE FtiCTIONS AND
INVESTIGATIONS THAT THAT EXCHANGE PERFORMS. SUCH
DOCLENTATION IS NECESSARY TO ASSURE THAT THE PHLX
IS CARRYING OUT ITS STATUTORY RESPONSIBILITIES
PROPERLY.







31



The Options Studiy's inspection of the AMEX revealed that trading oractices that may have been inconsistent with the Exchange Act or AMEX rules were often detected and investigated. Subsequently, however, the AMEX staff closed many cases with no action even though the circumstances suggested that a violation may have occurred. The Options Study found the AMEX case closing procedures troublesome because A4EX cases were seldomn formally prepared arnd, perhaps as a result, factual and legal argument and analysis were not as precise or thorough as the Exchange Act reauires. In addition, the Ai'4EX staff often closed cases because it was of the view that a panel of AMEX members would not impose disciplinary sanctions under the circumstances of the case.

As a result, the AMEX staff is effectively able to set the legal anid ethical standards for trading conduct on the AMEX floor with no involvement of the AMEX membership. Fiecently, however, the A14EX undertook to form a special committee of its Board of Governors, to review, amonq other things, all investigative and enforcement activities of the staff.

Pccordinqlv, the Options Study recommends:

THE AMEX SHOULD FORM A SPECIAL COMMITTEE OF ITS BOARD OF CVERNOKRS THAT WILL REVIEW THE INVESTIGATION AND ENFORCEMENT ACTIVITIES OF
THE EXCHANGE. THE CavIMITTEE SHOULD BE CCMR)SED,,
AS THE AMEX SUGGESTED,, OF FLODOR AND NONFWCOR
MEMBERS, EXCHANGE OFFICIALS AND A REPRESEI'IATIVE
OF THE PUBLIC. IN ADDITION TO) I'IS GENERAL REVIEW,,







32



THE COMMITTEE SHOULD SPECIFICALLY EXAMINE, AT
LEAST EVERY SIX MONTHS, EVERY INVESTIGATIVE FILE
IN WHICH THE INVESTIGATIVE AND ENFORCEMENT
ACTIVITIES OF THE STAFF HAVE BEEN COMPLETED.
THE FILE SHOULD IDENTIFY THE REASONS THAT THE
INVESTIGATION WAS INITIATED, THE STEPS THAT
WERE IAKEN TO INVESTIGATE THE MATTER, THE CONCLUSIONS THAT WERE REACHED CONCERNING EACH
ASPECT OF THE POTENTIALLY VIOLATIVE CONDUCT, THE RATIONALE FOR EACH CONCLUSION, AND FULL
DOCUMENTATION TO SUPPORT THE RESULT.

FURTHER, COMISSION INSPECTIONS OF THE AMEX
SHOULD EMPHASIZE A REVIEW OF CASE FILES
THAT ARE CLOSED AFTER INVESTIATION TO ASSURE
THAT AMEX ENFORCEMENT RESPONSIBILITIES ARE
PROPERLY CARRIED OUT.

n inspection of the MSE options surveillance program caused the

Options Study concern in two areas. First, although MSE documents

indicated the exchange had detected numerous instances of trading

that may have been inconsistent with the Exchange Act or MSE rules,

no records were maintained indicating whether any subsequent investiqation was done. As a consequence, it is impossible to determine

the regularity, adequacy, or extent of investigations of potential

improprieties that the MSE surveillance system detected. Second, the

case files that the Cotions Study reviewed demonstrated that MSE

investigations that were conducted were often incomplete and concluded

prematurely.







33


Accordinqly, the Options Study recommends:

THE COMMISSION SHOULD CONDUCT A COMPLEETE INVESTIGATION
OF THE MSE OPTIONS SURVEILLANCE PROGRAM. THE INSPECTION SHOULD SEEK TO DETERMINE WHETHER THE MSE HAS THE ABILITY
TO ENFORCE CCMPLIANCE WITH THE ACT AND MSE RULES WITH
RESPECT T0 OPTIONS TRADING ON THE MSE FLOOR.


b. Broker-Dealer Oversight


Each of the self-regulatory organizations has monitoring, investiqation, examinaticn, and disciplinary programs to assure that their brokerdealer member firms comply with the federal securities laws and the self-requlatory organization rules governing, among other things, selling practices. The Options Study reviewed the broker-dealer sales practice programs and investigative and enforcement files at the options exchanges and the NYSE and conducted interviews with officials of self-regulatory organizations regarding the operations of these programs. The Options Study found that brokerdealer oversiqht programs of the self-regulatory organizations have been inadequate to assure the protection of the public.

The self-regulatory organizations, in their oversight of member

firms, fail to use public customers as a source of valuable regulatory information and to collect relevant data from one another. Public customers are not routinely Questioned in conjunction with examinations and investigations of member firms and their associated persons and,







34



tneretore, seit-regulatory organizations frequently terminate investigations prematurely or tail to pursue potential violations uncovered by routine examinations. There is also no routine exchange a"ung selt-regulatory organizations of essential compliance information, sucn as tne results ot examinations, investigations and informal discipinary actions. Accordingly, the self-regulatory organizations in many instances have an inaccurate perception of the conduct of tnelr laetier tinrms.

vlucn valuable information available from member firms is not assembled arn evaluated uy selt-regulatory associations, primarily because the selt-regulators have not sought access to such data. moreover, usetul inltormation available trom government agencies is neither sought nor used routinely.

Investigations and examinations of retail sales practices by the selt-regulatory organizations normally concentrate only on detecting iijnauer rirmn tallures to toilow record-Keeping procedures established uy tWe rules or te sell-regulatory organizations governing, for example, t e opening ot accounts ana approving of transactions. Self-regulatory examination and investigative procedures are not adequately designed or utilized to detect substantive violations, sucn as use of deceptive sales materials, recommendations of options transactions unsuited to the customer, and excessive or unauthorized trading in customer accounts.







35


In conducting an inquiry arising out of a custoer's caplaint or a notification that a registered representative's employment has been terminated because of a possible rule violation, the selfregulatory organizations limit their inspection to the specific, often narrow, issues raised by the complaint or termination notice. These inspections do not consider whether other customer accounts of the sane registered representative may have experienced problems similar to those of the complaining customer. br do these inspections consider whether possibly related rule violations may have occurred which, for one reason or other, may not have been articulated in the customer's complaint or in the registered representative's termination notice. Moreover, the self-requlatory organizations are generally reluctant to resolve factual disputes between customer and firms, even though this task normally is necessary to determine whether misconduct has occurred.

Disciplinary action taken by the self-regulatory organizations has been ineffective in deterring future violations. Non-public letters of caution or other informal sanctions are too often impDsed in cases involving serious violations or injury to public investors. The self-requlatory organizations also allow their member firms to commit repeated rule violations without decisive remedial action.







36



Tn'e Options btudy discussed these and other concerns with the

selt-regulatory organizations. Tne Self-Regulatory Conference agreed ucat "it snoulu De possiole to establish some industry-wide objectives utor tn e conduct or a [uroKer-dealer tirm] examination so as to insure tue protection or investors, 'void regulatory duplication, and eiilminate regulatory voids". Thie Conference also agreed to consider estabilisniny programs "to promote a snaring of relevant information about uroKer-udealer compliance activities and to assist in the execution ol coILpLete, cuiprenenslve and thorough examinations of such firms." 20/ Lowara tinls end, the Conterence agreed "tnat a [central] repository couu ue utilized to provide each self-regulatory organization with imore information than is presently utilized tor purposes of registration uor personnel, customer complaints, investigations ana examinations." 21/ This central repository would include "at least all information reyarainy [registered representative] registration and termination, customer complaints, and ronnal actions taxen oy [the self-regulatory oryanizationsj and other regulatory codies...." 22/ The Options stuay ueleves that onese initiatives by the Self-Regulatory Conference are constructive and that they should De implemented as soon as possible.


2U/ ld. at pp. 7-6.

21/ Ia. at p. B.

22/ Ia. at p. 9.







37



The options Study believes that additional initiatives are necessary to remedy the deficiencies summnarized above, and to establish minimum standards for the performance of self-regulatory enforcement programs, and therefore recommends:

SELF-REGULATORY OFCAN IZAT IONS SHOULD BRO)ADEN
THE SCOPE OF THEIR EXAMINATIONS AND INVESTIGATIONS
AND ROUTINELY QUESTION PUBLIC CUSTOMERS IN ORDER TO0 RESOLVE DISPUTED ISSUES OF FACT, TO DETERMINE
WHETHER THERE MAY HAVE BEEN A VIOLATION OF THE
SECURITIES LAWS OR APPLICABLE RULES,, AND TO VERIFY
INFORMATION OBTAINED FROM ANOTHER SOURCE.

SELF-REGULATORY ORG3ANI ZAT IONS SHOULD DEVELOP WAYS TO
SHARE RELEVANT COMPLIANCE INFORMATION AND MORE EFFECTIVELY
ALLOCATE RESPONSIBILITY FOR BBOKER-DEALE R OVERSIGHT
AMONG THEMSELVES.

SELF-REGULATORY ORGANI ZAT IONS SHOULD RESTRICT INFORMAL
DISCIPLINARY ACTIONS TOX. CASES IN WHICH PUBLIC CUSTOMERS
HAVE NOT BEEN INJURED AND IN WHICH RULE VIOLATIONS ARE
MINOR OR ISOLATED.

SELF-REGULATORY OR33ANI ZAT IONS SHOULD AMEND THEIR RULES
TO PERMIT THEM TO ORDER RESTITUTION TO INJURED INVESTORS AS
A SANCTION IN APPROPRIATE DISCIPLINARY ACTIONS.


2. Trading Practices


To determine how market professionals use options in connection with investment and trading strategies the Options Study interviewed more than 100 professional stock and options traders.

In addition, the Options Study examined numerous investigative

records already established by the Comnmission and the self-regulatory organizations with regard to questionable trading practices such







38



as traue reversals, prearranged and fictitious trades, stock/option mahniulation ano tront-running ot DlocKs. Tne purpose of this effort was to uetenine wnetner certain marKet professionals nave access to ron-pu lic iarxet intornnation and enjoy other competitive advantages unat mlyf nt ue inconsistent witn the tederal securities laws and whether Commission or selt-regulatory organization action is necessary to prevent i nipulative or otbier improper conduct in connection with options trading. T ne Options Study, however, aid not conduct independent investigations uor particular trading situations. Nor was the Options Study aole to review ana analyze trading data or investigations that the selfreyulatory organizations initiated in sufficient detail to form the uasis ror regulatory recomtienoations. As a result, further study will ue required to aetenmine whether specific trading patterns can be iderititie which snoula be the subject ot proscriptive rules and to tomuutlate appropriate rules where necessary.


a. Professional 'rading

Institutional investors generally write caii options to limit

tne risk associated witi their stocK activities through the premiums receive. Utner options market professionals, however, employ a variety ot tracing strategies. Tnese options strategies seek to realize trading protrits in diverse ways: (I) speculation that marKet prices wii mDove either up or down, ; r stay within a given







39



range; (2) purchasing options at the bid price and selling at the of fer price to profit from the spread between the quotations; (3) trading that reduces positions to a limited or neutral risk posturc, to prof it from the passage of time or from price movements in theiunderline stck within a predetermined range; and (4) arbitrage.

The Options Study's review did not reveal that market professionals have competitive advantages that are inconsistent with the Fxchamae Act or the public interest. Additional information must be gathered, however, if the Commission and the self-regulatory organizations are to understand whether the patterns, relationships, and effects of stock and options trading by market professionals may b,- inconsistent with the public interest in a manner not currently perceived. In particular, more information is needed regarding patterns of trading near expiration and stock trading activities that might be designed to benefit unifairly pre-existing options posit ions.

Accordingly, the Cntions Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD USE THE
INTEGRATED SURVEILLANCE EATA BASE THAT THEY ARE
ESTABLISHING FOR STOCK AND OPTIONS TRADING TO DETECT
1ULAWFUL TRADING ACTIVITIES AND CONDUCT APPROPRIATE
ENFORCEMENT ACTIONS AND TO IDENTIFY PATTERNS CF
STOCK AND OPTIONS TRADING THAT SHOULD BE REGULATED
OR PROHIBITED. THE COMMISSION AND THE SELFREGULATORY ORGANIZATIONS SHOULD WCRK TOGETHER TO
ESTABLISH PRIORITIES FOR THESE STUDIES AND THE SELF-REGULATORY ORGAN IZATIONS SHOULD REGULARLY
REPORT THE RESULTS OF THE STUDIES THAT THEY CONDUCT
TO THE COMMISSION.







40


Accordinqlv, the Options Study recorrnrs:

THE DIVISION OF MARKET REGULATION SHOULD OBTAIN AND
REVIEW ALL INSTANCES OF OPTIONS AND STCK TRADING WHICH
ARE OR HAVE BEEN THE SUBJECT OF INFORMAL OR FORMAL
INVESTIGATIONS BY THE SELF-REGULATORY ORGANIZATIONS.
THE DIVISION OF MARKET REGULATION SHOULD REVIEW THIS DATA WITH A VIEW TOWARD PROPOSING ANTI- MANIPULATIVE
OPTIONS AND STOCK TRADING RULES WHERE APPROPRIATE.


b. Position Limits

Existing options exchange rules prohibit a person from holding

more than 1 ,000 short calls and long puts with respect to any underlying security. Position limit rules were adopted by the options exchanges primarily to minimize manipulative potential and to prevent the accumulation of larqe options positions that, if exercised, might affect the ix ice of the underlying stock.

The oxesent position limit rules prevent certain larger investors (orimarily institutions) from writing calls or buying puts against more than 100,000 shares of stock. As a result, the managers of certain large portfolios do rnot presently use options because writing options up to existinq position limits does not provide significant risk limiting capabilities for such large portfolios. Ib the extent that large investors own the stock underlying the options they write, they need not purchase stock to deliver on exercise of the calls they write or the puts they buy and, therefore, may not need to effect transactions which will substantially affect stock prices. As a result, a significant







41


portion of the theory underlying the position limit rules may not be applicable to such covered investors.

Numerous market participants, including professional traders, institutional investors, and self-requlatory organizations, have maintained that the position limit rules should generally be liberalized or otherwise modified. Further, the ability of some self-regulatory organizations to grant their marketmakers exceptions from these rules, and the manner and frequency with which exceptions have been qranted, has raised concern that the rules currently have an unequal imract on members of different self-regulatory organizations. It has been suggested that either the rules be made uniform for all market participants or that the self-regulatory organizations be permitted to liberally grant exceptions, especially in instances where a marketmaker miqht otherwise violate the rule when fulfilling his obligation to trade with public customers.

Pccordinqly, the Options Study recommends:

THE DIVISION OF MARKET REGULATION SHOULD UNDERTAKE A
COMPLETE REVIEW OF THE POSITION LIMIT RULES OF THE
OPTIONS EXCHANGES. THIS REVIEW SHOULD INCLUDE:
(1) THE POSSIBILITY OF ELIMINATING POSITION LIMIT
RULES, (2) THE FEASIBILITY OF RELAXING POSITION
LIMIT RULES FOR (a) ALL MARKET PARTICIPANTS, (b) FOR
ACCOUNTS WHICH HOLD FULLY PAID, FREELY TRANSFERABLE
SECURITIES CR (c) FOR "HEDGED" POSITIONS, AND (3)
WHETHER EXCEPTIONS FROM THE RULES SHOULD BE GRANTED
TO OPTIONS SPECIALISTS AND, IF SO, UNDER WHAT
CIRCUMSTANCES.







42



c. Claritication of Trading Rules

Following the commnencement ot the Options Study, the CBOE issued euucational circulars to its meiiubers discussing Doth specific trading activities that may be considered manipulative and the misuse of market intonnation involving those options trades which taKe place prior to tne public aisseminnation ot intormation concerning a large stock trade. The Options Study believes that this type of educational circular identities and helps to prevent improper activity, particularly in ue area ot tront-running.

Accordingly, the Options Study recommends:

ALL SELF-REGULaOiRY ORGMANIZATIONS SHOULD (I) ISSUE
IN'ERPETi'ATIONS OF THEIR ULES T'I1O MAKE CLEAR THAT FRONTUNNING IS INCONSISTN \T WITH JUST AND EQUITABLE PRINCIPLES OF TRADE BY ITb iAABERSf AND, (2) TAKE PROM 4Pr DISCIPLINARY
ACTION AGAIN ST THObE MEMBERS WHO HAVE BEEN FOUND 'TO HAVE
ENGAGED IN F JNT-RUNNING.

Tue Cat mission should also take steps to clarify the law when necessary or appropriate. In tne area ot related stock and options trading, tor example, there nas been much debate concerning the types or trading that might be considered manipulative. Wnile tne Cuu mission nas proceeded against intermarket manipulation in re-iance upon Section 10(o) ot the Exchange Act, and Rule O10b-5 tuiereunuer, the applicability of Section 9(a)(2) of the Exchange act to such activities remains unsettled.

Tre uncertainty arises because Section 9(a)(2) applies to "a

series ot transactions in any security ... creating actual or apparent active trading in sucn security or raising or depressing the price







43



of such security, for the purpose of inducing the purchase or sale of such security by others." Neither the Commission nor the courts has resolved the question of the applicability of this section to related stock and options trading. The Options Study believes that this issue should be resolved by making it clear that stock transactions effected to benefit options positions fall within the scope of Section 9.

Accordingly, the Options Study reccituiends:

THE COW$ISSION SHOULD ISSUE AN INTERPRETIVE RELEASE
OR~ INITIATE RULEMAKENG PROCEEDINGS SPECIFICALLY
TO) CLARIFY THAT INTER-MARKET MANIPULATIVE TRADING
ACTIVITY TNW)LVING OPrIONS AND THEIR UNDERLYING
SECURITIES MAY VIOLATE SECTION 9.

Shortly after listed option trading began, the options exchanges adopted so-called restricted options rules which were designed to prevent mwuarranted speculation in deep out-of-the-money options. restricted options rules tend to limit legitimate trading activities of somne options customers. The Options Study believes that improvements in the customer suitability and its enforcement may, at a future date, allow the elimination of the restricted options rules. Accordingly, the Options Study recoinmends:

THE DIVISION OF MARKET REGULATION SHOULD CONSIDER
THE ELIMINATION OF THE RESTRICTED OPTION RULES
AS SOON AS THE OVERALL EFFECTIVENESS OF' THE OPT ION4S
STUDY' S SUITABILITY RECOMMENDATIONS CAN BE EVALUATED.


3. Selling Practices

To examine the manner in %hich options transactions are recommended to public custaners, the Options Study reviewed public complaint






44



letters, retail sales practice examinations conducted by the Comission and the self-requlatory organizations and additional data, including the responses to a detailed questionnaire, provided by broker-dealers. Siqnificant problems related to options selling practices were found. These problems included solicitation of options transactions unsuited to the customer; excessive and unauthorized trading in customer options accounts; inadeauately trained registered representatives and supervisors; deceptive advertising and sales literature; and irregularities in options exercise practices.


a. Customer Protection

Both brokerage firms and self-regulatory organizations need to

improve their procedures to prevent sales practice abuses. As a first step, broker-dealers and the self-regulatory organizations should take steps to place the customer in a better position to detect sales practice abuses in his own account. If the customer does not have in his possession essential information about his own account in a form he can easily understand, the customer can not detect and prevent improper activities in which his registered representative might engage.


1) The 0CC Prospectus

One of the major regulatory safeguards intended to protect options

customers from possible abuses is a prospectus required by the Securities Act of 1933 ("Securities Act"). The options prospectus is published







45



by the Options Clearing Corporation ("0CC"), which technically is the issuer of all listed options. Exchange rules require that this prospectus be delivered to every customer at or prior to the time his account is approved for options trading. TIhe prospectus contains 56 printed pages describing, in considerable detail, information about options, their risks and the mechanics of options trading.

The current options prospectus was drafted to meet the requirements of the Commission's general registration form, Securities Act Form,S-1. This form is used when no other specialized form has been designated. While the 0CC has gone to considerable effort to simplify the language of the options prospectus, the Form S-1 is not designed to meet the

needs of both options buyers and sellers. The Options Study has concluded that information concerning listed options should be disclosed to investors in a manner readily understandable to a reader with no financial training and that information about options and the trading markets for options should be separated from information about the 0CC.

Compliance by the 0CC with the Securities Act can be satisfied by the filing of a special form of registration statement and prospectus desiqined for CCC as the issuer of options and adopted pursuant to the Commission's authority under the Securities Act. This special form would include information relating to the 0CC, including a description of its business and financial reports.























I~ ", -4 -






46



To provide investors with an appropriate disclosure document,, a new document prepared by OCC would be required under the Exchange Act to be delivered at or prior to the time of an options customer opens an account. This document, designed for persons without financial training, would provide investors with a simple description of the risks and uses of put and call options. This new document should include a glossary of terms; a description of

(i) the risks of options tradinq, (ii) the fundamental uses of options trading, (iii) the terms of options, and (iv) the mechanics of buyinq, wiring and exercising options; and a simplified discussion of transaction costs, margin requirements and tax consequences of option tradinq.

The effect of these recommendations would be to relieve CC

from liability under Section 11 of the SEcurities Act for disclosures relatina to a description and uses of options and the mechanics of the opt ions tradinq markets, matters with respect to which CC has no special exia-rtise or control. At the same time, potential options traders would be furnished with a disclosure document desinined specifically for their needs and, in particular, for the needs of those investors with little or no financial training.

TPccordinqly, the Options Study recommends.

THE COMMIISSION SHOULD ADO)PT A SPECIAL REGISTRATION
FORM UNDER THE SECURITIES ACT FOR CCC WHICH WOULD
NTXr REQUIRE CCC TOX DESCRIBE INFORMATION ABOUT OPTIONS
TRADING -AND SHOULD EXERCISE ITS AUTHORITY UNDER THE EXCHANGE ACT TO REQUIRE THAT A DISC LCSURE DOCUMENT







47



FILED UNDER THE EXCHANGE ACT DESCRIBING OPTIONS, THEIR
RISKS, AND THE MECHANICS OF OPrIONS TRADING BE PREPARED
BY OCC AND BE DELIVERED BY BROKER-DEALERS TO EACH OPTIONS
CUSTOMER AT OR PRIOR TO THE TIME THE CUSTOMER OPENS AN
OPTIONS ACCOUNT.


2) Customer Suitability

Another safeguard designed to protect the customer from. unethical or illegal selling practices is the brokerage firm's own evaluation of the customer's suitability to trade in options. The self-regulatory organizations have adopted rules establishing suitability standards which are to be applied by broker-dealer firms to prevent the firms and their registered representatives from making unsuitable recommendations to customers. The suitability rules of the options exchanges, however, do not match the suitability warning in the prospectus.

The current options prospectus states on the cover page in bold face type:

Both the purchase and writing of Options involve
a high degree of risk and are not suitable for many investors. Such transactions should be entered into only by investors who have read and understand this
prospectus and, in particular, who understand the nature and extent of their rights and obligations
and are aware of the risks involved.

The options exchanges do not require, as does the prospectus, that the customer understand the risks of recommended options transactions, except when the particular recommendation is to write (sell) uncovered calls or to write put options.






48


This important distinction can be seen in the general suitability

rule of the CBOE. This rule, which is similar to those of the other

options exchanges, requires only that a reqistered representative

who recommends options transactions to a customer:

shall have reasonable grounds for believing
that the recommendation is not unsuitable
for such customer on the basis of the
information furnished by such customer after
reasonable inquiry as to his investment
objectives, financial situation and needs,
and any other information known (to the
broker-dealer firm or registered representative] (Emphasis added.)

Only when the registered representative's recommendation is to write

uncovered call or put options does the CBOE rule require that the

customer should understand the risks involved. Under this paragraph

of the rule, writing uncovered calls or writing puts is deemed unsuitable

unless:

upon the information furnished by the customer,
the person making the recommendation has a
reasonable basis for believing at the time of making a recommendation that the customer has
such knowledge and experience in financial
matters that he may reasonably be expected to be capable of evaluating the risks of such transaction, and such financial capability as to be
able to carry such position in the option contract.
(Emohasis added.)

The Options Study believes that a customer should be made aware,

on an on-aoinq basis, of the risks of any and all options transactions

undertaken by the customer and that a brokerage firm should not be permitted to recommend any opening options transaction to a customer unless







49


the firm reasonably expects that the customer is capable of both evaluating the risks and bearing the financial burden of those risks.

'lb insure that this standard is met on a continuing basis, informnation concerning a customer's current financial resources, needs, and sophistication should be obtained by the brokerage firm. This information should be utilized in determining the suitability of options trading for a customer, first at the time a customer opens an account and again before a registered representative recommends a new, more canolex, or riskier options strategy than the type for which the customer has already been approved.

Without accurate and complete data about a customer 's financial txosition and objectives, a brokerage firm cannot make well founded decisions concerning the suitability of options trading for that customer. Too often, a registered representative, without detection, fabricates suitability information about prospective new options customers

solely in order to secure from his supervisor the required approval of transactions for an account. The State of Wisconsin has resolved this oroblem by requiring that the management of a brokerage firm send to each new optior -'ra copy of the completed suitability

information form relatin', chat customer. This process assures the customer an opportunity to review the information form, outlining his financial objectives and position, which the registered representative has already filled out.







0



i- ccoruinqiy, tne Options Study reconmeenas:

'llih; bLl-,F-REGUL.A!lURY ORG IZATWNS SHOULD REVISE
THLif< UP11UN6 bUlTAbILITY RULLS lU Pfd-)HIt3IT
A bRUKt;i-(-DEAL&. R FRW RECC1,14ENDING ANY OPENIM;
OP11ON6 Ti MbACTiWS 'W A CUSIUAER UNLESS lTiE FIRM HAS
A t(L AbU BASIS FOR BELIEVING 'MN.P THE CUSItl4ER
iS Ab ,L '1'0 THE RIL)Kb OF THE PAWICULAR
REC(A ,t ENDED TMNSACeION AND 16 FINANCIALLY ABLE 'W bhAR ThE RI6K6 UF THE REW41YIENDED POSITIONS.
'illb bELF-REGUL&WJRY ORGANIZATION SHOULD FORMER
'I!HEIR RULES -w REQUIRE:

ihi l! CUSrWiAL'R INF()i MA 2ION FOi iviS BE STANDARDIZED
i ND REVISED lU INDICKeE THE SOURCE OF SUITABILITY
INEOAvINTION ABOUT Tiit; OfIONS CUS'lUqER;

Tfit- P THE OF tACH FIR 4 SEND li'O
EVERY NEA Oi'IONS CUS'lUvkR FOR HIS VERIFICATION
i-i COPY U THL fURL-1 COMPLAINING THE CUSff 'S
6UITAi3lLITY lNFOA,,lNl'ION AND lhi- ll THE CURRENCY OF
INFOI evMUN ON SUCH FOiliS BE CONFIPMED SEMIANNW- LLY;

'ihi f lviE WLR FIAAS BE PA)HIBITED FROM RECMAENDING
u h;NiNG Oi'I(A46 TfU SAMONS '1'0 CU&fOMERS WHO REFUSE 'iU PAUVIDE bUITABILl'i'd INFOM-iNfION, AND FOR WHW 'lhE
i)U N(J2 OfhLi4N16E hi-WE INDEPENDENTLY VERIFIED INFOf Lv"21ON bUkVICIEW FOR THE SUITABILI'l"Y D&2EWvlINA PION; AND

Tfii i Plii 'libkR Fl& IS AWixf ADDITIONAL SAFEGUARDS FUR THE
PAYPt;(2fION OF EACH Oiji'IONS CUS'M4ER IN' WHOSE ACCOUMP
D16LW:fl iuN is 1110 BE EXLRCISED.


3) Opening Account Statements

tven it a custuner is aDie to understand tne ri-sKs ot his options

transactions, ne may L)e contused by his account statement. Account

star-ements reriectiny options transactions sent by brokerage firms

w Uieir customers are I:re(4uentiy ditricult to understand. Not oniy

lilay a custatier nave clitticuity understanding tne options transactions










reported in his statement, he may also have difficulty determining whether he has earned a profit or sustained a loss. In certain cases, even the customer's registered representative has been unable to calculate the customer's profit or loss on the basis of the account statement.

Moreover, most firms do not provide account statements which

state clearly the- individual commissions charged on each transaction or summarize the commission charges for the period covered. Nor do these account statements show the customer the current equity in his account after valuing all the customer's positions at current "marked-to-market" prices, although a few firms have begun recently to calculate this fiqure for their customers. Tb add to these omissions, account statements do not indicate the amount of certain other expenses. Such information is essential for the customer when he attempts to evaluate the financial consequences of his options transactions.

Akcordinqlv, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT RULES REQUIRING THE OPTIONS CSTCMER'S ACCOUNT STATEMENT TO SHOW THE EQUITY IN THE CUST(I4ER'S
ACCOUNT WITH ALL OPTIONS AND SECURITIES POSITIONS
MARKED-TO-MARKET AND THE YEAR TO DATE PROFIT OR LOSS IN THE ACCOUNT CLEARLY SHOWN. THE OPTIONS
CUSTOMER'S ACCOUNT STATEMENT SHOULD ALSO SHOW
THE AMOUNT OF MARGIN LOANS OUTSTANDING AS WELL
AS CCMISSION CHARGES APPLICABLE TO EACH TRANSACTION AND OTHER EXPENSES PAID OR PAYABLE FOR THE PERIOD COVERED BY THE ACCOUNT STATEMENT AND YEAR
TO DATE.







52


b. Responsibilities of Broker-Dealer Firms

Brokerage firms are responsible for dealing with customers in a fair, ethical and professional manner. lb fulfill these responsibilities to the greatest extent practicable, the Options Study

believes that firms must:

--assure that their registered representatives are properly
trained;

-establish and implement appropriate supervisory controls over
their registered representatives, including establishing and implementing adequate programs for reviewing customer
accounts;

--compile and maintain adequate information and records about
the sophistication, needs and resources of each customer;
and

-assure that communications with the public through advertising or other means are truthful and accurate.


1) Qualification of Registered Representatives A primary obligation of a broker-dealer firm to its customers should be the assurance that its registered representatives the people who have the most frearuent and significant contact with public custcxners

- are properly trained and understand their business and responsibilities. Inadearuate or inconsistent professional qualification standards adopted and applied by the self-regulatory organizations and broker-dealers, however, permit untrained registered representatives to recotrrend options transactions to customers.







53



Options exchange rules require that all sales personnel be "opt ions qualified" before they can service custctner opt ions accounts, but these qualifying standards appear to be ineffective. In the first place, the examinations now used to qualify both new and experienced registered representatives to sell options are of questionable utility. The qualifying examination given to a new registered representative can be passed by him

-- at whiich point he may begin selling stocks and options even if he missed every question relating to options. The options qualifying examination, qiven to an experienced registered representative wno wishes to begin to sell options, is not administered under controlled test

conditions to assure that the person does in fact know the answers he is qivinq on the examination. In addition, although options exchanges impose minimum training requirements for options qualification, these requirements are largely unenforced. Because of these inadequacies, many registered representatives now servicing the accounts of options customers may lack the necessary knowledge and skill to perform their functions professionally and to fulfill their legal obligations.

Accordingly, the Options Study recommu~ends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPTP
RULES TO REQUIRE THAT: (A) THE REGISTERED
REPRESENTATIVE "OPTIONS QUALIFYING" EXAMIINATIONS
SHOULD BE REVISED TO REQUIRE A THOROJUGH
KNOWLEDGCE OF OPTIONS AND THE OPT IONS EXCHANGE
RULES DESIGNED TO PROCYPT CUSTOMERS. THESE
EXAM1INATIONS SHOULD BE READMI-NISTERED TO ALL
OPTIONS SALESPERSONS, AND ALL EXAM'INATIONS6
SHOULD BE GIVEN UNDER CONITROLLED SURROUNDINGS
BY INDEPENDENT EXAMINERS; AND (B) THE TRAINING







54


OF REGISTERED REPRESENTATIVES WHO RECOMMEND OPTIONS TRANSACTIONS TO CUSTOMERS SHOULD BE
FORMALIZED TO INCLUDE A MINIMUM NUMBER OF HOURS
OF APPROVED CLASSROOM AND 014-THE-JOB INSTRUCTION.


2) Supervision of Registered Representatives and of Custoffer Accounts

The problems caused by an untrained sales force may be exacerbated by unqualified supervisors and by inadequate supervision. According to the existing rules of the options exchanges, new customer accounts must be approved for options trading by an officer of the firm who has passed an advanced test the registered options principal (uROP") examination. But these same rules do not require that each sales office be supervised by a person who is qualified as an ROP although these sales offices may be recommending and effecting

options trades. In many firms, in fact, the supervisor of a sales office is not so qualified. The ROP qualification examination is deficient in that it concentrates on the mechanics of listed options rather than the responsibilities of supervisors. Furthermore, some ROPs have never passed a qualifying examination controlled by independent examiners. As a consequence, the day-to-day conduct of the options business at the branch level of many firms is supervised by individuals who may have little, if any, understanding of options trading.

The Options Study also found substantial inadequacies in the

systems that broker-dealer firms use to oversee the activity in customer accounts. In numerous instances, firm Employees themselves have circum-







55


vented these systems. For example, options exchange rules require,

as a means of control, the initialing of discretionary orders

by a branch manager. This responsibility, however, is somnetimnes*

deleqated to a particular registered representative wbo hima-lf

needs to be controlled. Supervisory problems can multiply when a

salesman is considered "special ." For example, where a firm's computer

identifies potential problems in an account, branch managers and

other supervisors too often fail to take action because the registered

representative involved is a "big producer" of cormiss ion revenue.

Mother flaw in supervision can occur because many firms

are sometimes unable or unwilling to compile current, accurate

information about the status of their individual customer accounts.

Deprived of this information, a supervisor's ability to focus quickly

on critical problems in his own office is significantly curtailed.

Pccordinqlv, the Options Study recommends:

THE SELF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RULES TO( REQUIRE THAT: (A) THE ROP QUALIFICATION
TEST BE REVISED AND ALL ROPS BE REQUIRED TO0
TAKE THE REVISED TEST UNDER CONTROLLED CONDITIONS;
(B) THE PRINCIPAL SUPERVISOR OF ANY BRANCH OR
OTrHER OFFICE ACCEPTING CUSTOMXvER OPTIONS TRANSACTIONS SHOULD BE QUALIFIED AS AN ROP; (C) EACH
FIRM DESIGNATE A POLICY LEVEL OFFICIAL WHO,,
ABSENT A CLEAR SHOWING OF COMPELLING CICUMSTANCES,
HAS NOI SELLING FtUCTION 1O OVERSEE THE FIRM S
OPTIONS COMPLIANCE PROGRAM; (D) THE SELF-REGULATORY
ORGANIZATIONS DEVISE A UNIlFORM SYSTEM OF SUPERVISORY PROCEDURES FOR FIRMS OFFERING OPTIONS
TO PUBLIC CUSTOM4ERS; (E) THE HEADQUARTERS OFFICE
OF EACH BROKER-DEALER ACCEPTING OPTIONS TRANSACTIONS
BY CUTOM1I~ERS SHOULD BE IN A POSITION TO REVIEW EACH CUSTOMER OPTIONS ACCOUNT ONJ A TIMELY BASIS
TO0 DETERMINE:







56


--COMMISS IONS AS A PERCENTAGE CF
EQU ITY IN A CUTECflMER' S ACCOUNT;

-UNUSUAL CREDIT EXTENSION;

-REALIZED AND UNREALIZED LOSSES IN
EXCESS OF AN ESTABLISHED PERCENTAGE
OF THE CU.E CMER'S EQUJITY;

--UNUSUAL RISKS OR UNUSUAL TRADING
PATTERNS IN A CUTOM~~tER' S ACCOUNT;


3) Recordkeeping and Communications with Customers Additional problems in the area of customer accounts arise because many firms fail to maintain adequate records concerning their customers and their communications with customers. These records should include materials relation to: information about the customer's general backairound, financial needs, and investment objectives; any complaints the customer may have expressed orally or in writing; the method of allocatinq exercise notices to customers; and copies of worksheets and performance reports which registered representatives send to their customers in conjunction with options recommendations.

Customer complaints are frequently not available to the management

at a firm's headcoiarters because some firms keep them on file only at the branch office which originally gave rise to the complaint. As a result, it is difficult for the headcaiarters office to ascertain developing branch office problems. On~ the other hand, sane firms maintain customer suitability information only at the headquarters office and do not maintain copies at the branch office for use by local supervisors.







57W


The quality and accuracy of other forms of broker-dealer coij-iications with the public often fall below acceptable standards. L or exiple, the quality of options advertising and sales literature vary significantly from firm to firm and these materials too often contain misleadng or inaccurate statements. Several options seminar scripts, prejarc< by the brokeraqe firms themselves, were found to be similarly flawed.

Lacking sufficient supervision, registered representatives are often at liberty to send worksheets to their customers which detail

tromisinq returns on recommended options transactions. Worksheets are frequently included as part of a promotional package, along with performance reports of the particular firm's options program. The Options Study has found that these worksheets and reports are frecuentlv inaccurate and that worksheets sometimes contain only e tons of return which mislead customers. Copies of these documents, which can be usef in detecting imgroper sellin oractices, are often not maintained for review by the firm.

Accordinqly, the Options Study recommends:

THE SEIF-REGULATORY ORGANIZATIONS SHOULD ADOPT
RECORDKEEPING RULES WHICH REQUIRE THAT MEMBER
FIRMS: (A) KEEP COPIES OF CUSTOMER COMPLAINTS, C[USTCER SUITABILITY INFORMATION AND CUSTOMER ACCOUNT STATEMENTS AT BOTH BRANCH OFFICES AflD
THE HEADQUARTERS OFFICE; (B) KEEP COPIES OF ALL WCRKSHEETS, PERFORMANCE REPORTS AND OTHER CCMMUNICATIONS BETWEEN REGISTERED REPRESENTATIVES
AND THEIR CUSTOMERS, AND IMPROVE SUPERVISION OVER
THE USE OF THESE SELLING DOCUMENTS ; AND (C) KEEP RECORDS CONCERNING RATES OF RETURN ON INVESTMlENT
QUOTED TO OPTIONS CUSTOMERS AND IMPROVE SUPERVISION
OF AND DISCLOSURE CONCERNING OPTIONS PRCG&PIS AND
SEM INAR PRESENTATIONS.







58


4) Exercise Allocations

Finally, the Options Study observed several instances of misallocation of exercise notices by broker-dealers, including situations in which firm Practices concerning customers' exercise allocations have resulted in iniury to public customers. Some firms did not have, or could not provide, records which disclosed the method by which exercise notices

were assiqned. For this reason, it was sometimes impossible to determine satisfactorily whether all firms have been following ootions exchange rules regarding the allocation of exercise ntices. A uniform allocation system, coupled with consistent recordkeepinq requirements, would prevent unfairness in the allocation process and make the detection of irregularities in the exercise practice of broker-dealers easier.

Accordingly, the Options Study recommends:

ThE SELF-REGULATORY ORGANIZATIONS SHOULD
ESTABLISH A UNIFORM EXERCISE ALLOCATION
PROCEDURE AND SHOULD REQUIRE THAT MEMBER
FIRMS KEEP RECORDS WHICH ARE ADEQUATE
TO PERMIT REVIEW OF EXERCISE ALLOCATION
PRACTICES.


4. Financial Structure


The Otions Study examined the financial structure of the

options market to determine whether sufficient safeguards and controls exist to protect the market place and, ultimately, the public from beinq harmed by the financial failure of either broker-dealers







59



carrying public customer or other broker-dealer accounts or broker-dealcers on the floor of an exchange with market making responsibiliti( s. These safeguards and controls include: (1) the Commission's net capital and customer protection rules; (2) the Comrmission's arnd SR)'s financial reporting and early warning requirements; (3) the Federal Reserve Board ("FRB") initial margin requirements and self-regulatory maintenance margin requirements; (4) the Securities Investor Protection Corporation ("SIPC") protections; and (5) the OXIC financial requirements

and margin requirements. After reviewing these safeguards and controls, the Options Study has concluded that numerous steps should be taken to make these safeguards more responsive to the risks associated with options positions without impo'sing substantial additional net

capital requirements on market participants.


a. The Commission's Net Capital Rule

The Commission's net capital rule requires that broker-dealers

maintain a sufficient cushion of liquid assets to satisfy all customers, claims. It establishes minimum net captial requirements ranging from $2,500 to $100,000, depending on the nature of the firm's business, with broker-dealers that carry customer accounts subject to a minimum $25,000 requirement. In very general terms, net capital equals net worth less (1) non-liquid assets and (2) a deduction (called a "haircut") which reflects the general market risk for securities, ranging from 1/8 percent for commercial paper to 30% of the market







60


value for common stock. This rule also contains provisions limiting a broker-dealer's volume of business in relationship to its net capital. With respect to options, the net capital rule limits the amount of business an OCC member can finance and guarantee for specialists, competitive marketmakers or registered options traders who trade on the floor of an options exchange ("market makers"). More specifically, the rule limits the qross deductions for positions in marketmaker accounts to ten times the OCC member's net capital.


1) Increase of Deductions in Computing Net Capital

Based on computer analysis and impact studies of data requested, the Ootions Study found that existing financial safeguards provide sufficient capital to protect both the market and public investors

in periods of normal volume and price movements. The Options Study is concerned, however, that these financial safeguards with

respect to OCC member clearing firms that carry the accounts of options marketmakers may be inadequate during times of abnormal volume and price surges. The amount of deductions currently required in coputinq a clearing firm's net capital appears inadequate in three areas: (1) deductions for options exercisable at prices near or at the current market price of the underlying security ("near" or "at-the-money" options) which are subject to volatile percentage price movements; (2) gross deductions for marketmaker







61



positions carried by a clearing tirm in relation to its net capital

to liit the voiLuie 01 clearing ousiness that can be done; and

(3) Idc.K ot oeauctions to recognize tne additional risks ot marketIIaxer accounts carried oy an 0CC iienter clearing firm holding

in ttue aggregate in excess ut 10 percent 01 the outstanding open

interest in any one options class ("concentrated positions").

Accoralingly, the Opt ions Study recofmenals:

THE CUk-1kSIP4 SHOULD CONSIDER( REVISING ITS
Will CAPI'IAL }
INCREASE THE L)EDUC'&ION IN CCk1PTING NET CAPITAL
r-UR NEAR OR AT-THE-MONLY OP 2IOc4S 13Y PROVIDING
IHAT ltHE DEDUCTIONS FOR SHOW] OPTIONS POSITIONS
IN ivirl iRtAfh;R OF (i) 75 PERCENT' OF TE PREMIUM VALUE,
(ii) 75, OR (iii) 5 PERCELir OF THE f,1ARKETf
VALUE OF- '111L UNDERLYING SrlPXK REDUCED BY
2HE ktU14tI iY WIHIC-H THE EXERCISE PRICE OF THE
UR.QION VAItidES FilLX4 THL CURR[NP MARKL' PRICE
1A)R ThE; STOCK.

RLWUCt. THE PLI j.) NETf CkPITAL, RULdGFU-i IME OPT IONS AND S'iUCK i4)bITIONS CARRIED BY A CLEARING FI14v FO)R


REQUIRE AN ADDITIONAL CHARGE IN AN 0CC MEMBER',,.
CUQ1PW1A2ION UF ITS NET CAPITAL FOR ANY NET LODNG
W NeT' 6H0R2 uPTIONS POSITIONS IN ALL MVAKET
MkKtI( tCCOU1426 GUARANI'LD BY THE 0CC MVE,,IBER
WHICH ARL IN EXCESS OF 10 PERCENT OF 'MJE OPEN
ItWERE&ST IN THE OPTIONS CLASS. r'IrtfS DEDUCTION
SHOULD bE EQUAL 'IYU AN ADDITIONAL 50 PERCEN92
OF THE CHRGE (ThIE&415E REQUIRED FOR EACH
SERIES IN THf-AT OPTIONS CLASS.





























4-7 )- 7






62


2) Net Capital Deductions for Marketmaker Clearing Business


The net capital deductions that result from transactions in marketaker accounts carried by a clearing firm must be made on the same day the transactions occur, although these transactions do not clear until the next 'av. Although this requirement was adopted with an understanding that options transactions clear the next business day, it results in a clearing firm having to maintain a net capital position in anticipation of these charges. Tiyically, the net capital deduction for other securiities transactions by broker-dealers, however, is not made until the (lay the transaction normally clears (settlement date). For example, no charge is made to net capital on the purchase of stock by a brokerdealer until settlement date, generally five business days after the purchase. The Ontions Study has concluded that the clearing firms should have until the next business day after their marketmaker charges arise to make the required net capital deduction and, if necessary, to out aJditional capital into the firm or to obtain additional capital from their marketmakers. his change in the net capital rule would not relieve a non-clearing marketmaker of his responsibility to have ecmity in his account at the end of each day.

While this recommended change may have the effect of reducing the amount of net capital clearing firms must maintain on a regular basis, other recommendations of the Options Study will increase