contents

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CONTENTS Letter of transmittal_ Digest of report_ The special study of the options markets staff list ..................... Glossary_

IlI v x~i xv

CHAPTER I--Introduction: A. The growth of listed options trading_ B. Effect or listed options trading on the securities industry ........ C. Studies of economic effects of listed options trading___ D. Summary and conclf~sions of the options study_ 1. Self-regulatory organization systems .... (a) Market surveillance_ (1) American Stock Exchange surveillance information and audit trail ............ (2) New York Stock Exchange surveillance information and audit trail_ (3) Firm proprietary and customer trading information__. (4) Options clearing corporation position adjustments ...... (5) The sharing of surveillance information and the allocation of regulatory responsibility_ _ _ (6) Investigation and-enforcement (b) Broker-dealer oversight_ 2. Trading practices_ (a) Professional trading (b) Position limits .... (c) Clarification of trading rules_ __ 3. Selling practices_ (a) Customer protection___ (1) The OCC prospectus .... (2) Customer suitability (3) Opening account statements ............ (b) Responsibilities of broker-dealer firms_ (1) Qualification of registered representatives_ (2) Supervision of registered representdtives and of customer accounts .... (3) Recordkeeping and communications with customers .... (4) Exercise allocations 4. Financial structure (a) The Commission’s net capital rule (1) Increase of deductions in computing net capital (2) Net capital ded~tions-~or marketmaker clearing business ...... (3) Marketmaker minimum net capital ..... (4) Financial requirements of upstairs dealer firms .... (5) Marketmakers that are OCC members___ (b) Options specialist stock credit__ (1) Stock hedge__ (2) Limit on stock qualifying for specialist stock credit_ _ 5. Market structure .... (XXVII)

1 9 12 18 19 19 21 24 25 26 27 30 33 37 38 40 42 43 44 44 47 50 52 52 54 56 58 58 59 60 62 63 64 66 67 68 71 72

XXVIII CHAPTER II--Fundamentals of Exchange Traded Options:

A. Characteristics of options_ 73 1. Conventional OTC options compared to listed options .... 73 2. The options contract__ 76 3. Stock price considerations in listed options_ 82 4. Short-term character of options trading__ 83 5. Transaction costs ....... 87 6. Options pricing models__ 90 7. Examples of the effect of options contracts .... 96 (a) Call option__ 97 (b) Put option ...... 99 (e) Gains or losses tc options buyers areoffset by losses or gains to options sellers_ _ 102 B. Principal strategies 106 1. Introduction_ 106 2. Ten basic strategies_ 107 3. Survey of investor use of option strategies___ 114 4. Writing options for premiums ....... 117 Exhibit I: The relationship between puts, calls, starddles and stocks 121 CHAPTER III--The Use of Options By Professional Traders: Introduction_ 1. On floor market participants___ (a) Obligations_ (b) Privileges. (c) Options trading strategies_ (d) Stock/options trading strategies_ 2. Upstairs firms_ (a) Advantages enjoyed by upstairs firms__ (b) Arbitrage trading (1) Conversion and reverse conversion arbitrage .... (a) Conversion arbitrage ...................... (b) Reverse conversion arbitrage .... (2) Hedged short selling (3) Merger or exchange offer arbitrage ............. (4) Discount options arbitrage .... c. Block trading d. Creation of synthetic puts___ 3. Institutional investors ....................................... 4. Specific trading abuses ....................................... (a) Fictitious trades__ (b) Prearranged trading ................................. (e) Chumming .......... (d) Stock option manipulation ........................ (1) Minimanipulation___ (2) Capping and pegging (3) Statutory prohibition of manipulation__ (4) Problems of proof and the need for data ...... (e) Front-running .............................. 5. Trading rules ............................................. (a) Position limit rules ................................ (b) Restricted options rules

125 129 129 132 135 138 144 144 147 148 149 151 153 155 158 159 163 165 169 169 170 171 173 173 175 176 178 183 189 189 193

XXIX CHAPTER IV--Self-Regulatory Organization Surveillance of the Standardized Options Markets: I. Introduction .............................................. II. Methodology ............................................ III. Surveillance infol marion__ 1. The sources of surveillance information .... 2. The organization of capture of sm veillanee i-£f-o~’~a~i~)~ (a) Transaction information__ (b) Clearing information (c) Account information ......................... 3. Conclusions and recommendations .......... a. Surveillance info~ mation_ _ (1) AMEX surveillance information and audit trail___ (2) NYSE surveillance information and audit trail ............................ (3) Stock market reconstruction ........... (4) Firm proprietary and customei trading identification ............... (5) Custome~ account identification_ (6) OCC position adjustments_ b. Surveillance techniques_ (1) Surveillance techniques and smT~eillance information (2) The sharing of surveillance information and the allocation of regulatory responsibility .............................. (3) Improving options exchange surveillance techniques ........................... (4) Uniform repoating requirements_ IV. Investigation and enforcement .............................. 1. The CBOE and PSE ................................ 2. The PHLX ........................................ 3. The AMEX ........................................ 4. The MSE .......................................... Table 1--Surveillance data Available ................................ Table 2--Compmison of surveillance data available to surveillance data captured .................................................

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197 201 203 203 208 208 212 214 219 219 220 223 230 233 236 238 243 243 244 252 253 254 255 257 258 263 207 218

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

265 266 267 269 270 271 273 274 275 276

XXX Appendix Exhibits*: 1. Trading procedures and trade matching operations of the AMEX, CBOE, MSE, PHLX, PSE, and NYSE; surveillance techniques of the AMEX, CBOE, MSE, PHLX, and PSE. 2. Sample inspection outline and inspection information request (CBOE). 3. CBOE marketmaker minimanipulation and capping investigation (Case No. M 7145). 4. PSE expiration study. 5. CBOE capping investigation (complaint No. M 8018). 6. AMEX capping investigation. 7. AMEX capping investigation. 8. N YSE expiration study. 9. CBOE prearranged trading investigation (complaint No. M 8080). 10. AMEX prearranged trading investigation. 11. CBOE prearranged trading investigation (Case No. M 7052). 12. CBOE 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 in.vestigation. 16. Inside 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 sm’veillance expenditures. Table D: Optic.us exchange cleared contract volume. CHAPTEt~ V--Options Selling Practices:

~)age

Introduction ...................................................... 289 A. Registered representative qualification, preparation and motiva-

tion ...................................................... 296 B. Supervision of accounts ...................................... 314 C. Suitability ................................................. -336 D. Disclosure documents ....................................... 369 E. PrCmoting options--general problems___ 384 F. Promoting options--specific methods .......................... 402 G. Promoting options--investment programs__ 425 H. Options trading in customer accounts ......................... 440 I. Exercise problems .......................................... 477

CtlAPTER VI--Self-Regulatory Organization Oversight of Retail Firms and Their Associated Persons:

I. Introduction .............................................. 487 II. An Overview of SRO compliance programs_ 492 A. Monitoring programs ............................... 492 1. Employmen~ and termination of registered representatives ............................... 493 2. Customer complaints ......................... 494 3. Advertising ................................... 494 4. Financial responsibility early warning systems ....496 5. Credit monitoring ............................ 496 B. Cause examinations ................................. 497 C. Routine examinations ............................... 498 D. Disciplinary actions .............................. 501 *These Appendix Exhibits are available publicly in the Commission’s Public Reference Room and, therefore are not published as a part of this report.

XXXI

CHAPTEt~ VI--Oontinued III. Obtaining compliance information ...........................502 A. Public customers___ 502 B. SROs 507 1. Sharing of information_ 507 2. Coordination of compliance programs_ 516 C. Government agencies ............................... 518 D. Retail firms_ 520 1. Accessibility of customer complaints and account information ..... 520 2. Reporting requirements ...................... 524 IV. Deficiencies in 8140 examinations ..... 530 A. Limited scope of examinations ...................... 530 B. Poor selection of accounts for review ....... 537 C. Inadequate depth of account examinations_ 540 D. Reliance on firms for assistance ..................... 544 E. Failure to resolve disputed issues of fact .... 547 F. Inadequate resources 549 V. P~emedial actions .......................................... 550 A. Extent of disciplinary proceeding ......................551 B. Use of informal sanctions 554 C. Reasons for inadequate sanctions--restrictive SlY0 policies .......................................... 561 D. SRO internal supervision ............................ 564 E. Restitution as a sanction ............................ 565 F. SRO disciplinary proceedings: a final note___ 566 VI. The need for minimum SRO compliance standards ............567 Table I--Number of options related sales practice (or capital/sales practice) examinations conducted by SROs ................................ 500 Table II--Summary of SI40 examination and disciplinary action as to firm XYZ ..................................................... 509 Table III--Summary of SRO information on selected securities salesmen___512 Table IV--Selected comparison of complaints reported to NYSE and complaints received by two N YSE member firms in 1977 ............. Table V--Summary of types of options related violations detected by SROs in their 1977 sales practices and capital/sales practice examinations of firms with options commission income in excess of $1,000,000__ 539 Table VI--Options related sales practice disciplinary actions brought by the SROs as of March 1978 ...................................... 553 Table VII--Summary of disciplinary action by an SRO against firm ABC___ 555 Exhibits : Options study questionnaire set to the options exchanges (App. A*). Options study questionnaire sent to the N YSE (App. B*). Options study questionnaire sent to the NASD (App. C*). Summary of SRO options related examinations and investigations of firm DEF for 1973-1978 (App. D) ............................ Letter to l~ichard Teberg from the Self-P~egulatory Conference (App. E) ........................................................ Letter from Van P. Carter ~o GerMd Foley (NASD) (Oct. 11, 1978) (App. F) ................................................... Summary of statistics relating to SIlO routine sales practic~ examinations (App. G) Summary of SR(~ ............................................. financial resom’ces (App. H) ....................

570 577 590 604 611

*These appendix exhibits are available publicly in the Commission’s public reference room and,therefore, are not published as a part of this report.

XXXII

CHAPTER VII--Financial Regulation in the Options Markets: Introduction .... Broke~-dealer financial regulation ........ 1. The Securities Investor Protection Act 2. Commission action .... (a) Commission’s customer protection rule_ (b) Commission’s uniform net capital rule___ 3. The Options Clearing Corporation financial rules_. (a) OCC clearing members ....... (b) OCC member capital requirements_ (c) Commission’s net capital requirements___ (d) OCC settlement requirements (e) OCC clearing fund 4. Study of the financial integrity of the options markets ....... (a) Margin and clearing fund deposits ..... (b) Market makers and market maker clearing fir~ns .... 5. Recommended change~ to the net capital rule__ (a) Concentrated positions_ (b) Short positions in near or at-the-money options ...... (c) Restriction on volume of business carried (d) Market maker minimum net capital_ (e) OCC members and their affiliates that are market makers. (f) Immediate charges to carrying firm under the net capital rule_ (g) Conversion--reverse conversion positions__ (h) Financial requirements of upstairs dealer firms ...... Options specialist and stock credit ............................... 674 1. Specialist accounts__ 676 2. Good faith credit ....................................... 3. Free-riding and bona fide hedging_ 4. Options pricing formula .... 5. Limit on stock qualifing for specialist stock credit_.

Exhibits: 1. SEC reporting forms X-17A-5 part II and part IIA__ 2. Options study letter to OCC, dated May 5, 1978 and attachment_ 3. Options study letters to AMEX, BSE, CBOE, MSE, NASD, NYSE, PHLX, and PSE, dated June 7, June 16, and June 27, 1978 and attachments_ 4. Options study financial and o-perational questionnaire: (a) Form A ...... (b) Form B__ 5. Options floor participant equity: (a) All options exchanges (b) AMEX ............................................. (e) CBOE_ (d) MSE .... (e) PSE ........... (f) PHLX ............................................. 6. Options floor partiepiant equity requirements .......... 7. Letter from the staff of the Federal Reserve Board, dated December 5, 1978 ...............................................

615 620 620 621 621 622 625 625 628 630 632 639 640 643 646 649 649 652 655 657 661 663 665 667 678 680 684 691

693 695 705 763 768 769 770 771 772 77 3 774 775 776

CHAPTER VIII--Issues of Structure in the Standardized Option Markets: I. Introduction ............................................. II. The statutory standards ............ A. A national market system ..... 1. A national market system and SEC authority-_2. Objectives of a national market system_ 3. The elimination of unnecessary regulatory restrictions ..... 4. Communication among and dissemination of information about securities markets 5. Multiple trading_ B. The basic statutory goals .....

779 782 782 782 786 790 792 795 797

CHAPTER VIII--Continued III. Multiple trading of standardized options_ __ A. The effects of multiple trading of standardized options__ 1. The effects of multiple trading on the quality of markets for multiply traded option classes .... 2. Competition among market centers ............ B. Market fragmentation .............................. 1. The extent of market fragmentation for multiply traded option classes ......... 2. Brokerage film order routing decisions in the fragmented market environment ............ 3. Market fragmentation, option pricing, and order interaction_ _ _ C. Conclusions ....................................... 1. The multiple trading of standardized options and . the Exchange Act ..... 2. The multiple trading experience ...... 3. Market fragmentation and the Exchange Act___ 4. Primary market designations and automated order routing 5. The multiple trading of standardized options and recent initiatives toward the development of a national market system ........... IV. The integration of trading of options and their underlying Securities .............................................. A. The general considerations ...... 1. The quality of markets ............. 2. The regulatory concerns .......... (u) M~rket information and competitive advantage (b) Manipulation and other improper trading practices__ (c) Potential conflicts in marketmaking obligations ...... (d) Market surveillance_. 3. The extent of integration ........ 4. Characteristics of the exchange (a) Primary and secondary exchanges__ (b) The ma~ketmaking systems ...... B. Conclusions ....................................... 1. The gradual approach ........... 2. Principles of general applicability and the statutory standards .............................. 3. The principles applied ........................ V. An ove~-the-counter market for standardized options .......... A. Standardized options and underlying securities traded exclusively in the over-the-counter markets ......... 1. The absence of real-time last sale reporting for underlying securities traded exclusively in the over-the-counter markets ..................... 2. Representative bid and ask quotations for securities traded in the over-the-counter markets__ B. T~ading exchange listed options in the over-the-counter markets ...... 1. Fragmentation and internalization 2. Market information and competitive advantages of over-the-counter marketmakers ........... 3. Over-the-counter markets and a national market system which would include standardized options ..................................... C. The integration of trading of options and their underlying securities in the over-the-count~r markets ............ 1. Market information, competitive advantage and improper trading practices .................. 2. Marketmaking obligations and commitment to the marketplace ............... 3. Market surveillance in the over-the-counter markets ..... 40-940 O - 79 - 3

809 824 827 828 830 839 843 843 846 849 853 864 870 876 877 880 880 885 892 896 900 903 904 907 916 916 917 920 926 930 933 938 945 946 948 951 952 956 963 968

XXXIV

CHAPTER VIII--Continued

~’age D. Conclusions_ 972 1. Real-time last sale reporting and representative bid and ask quotations___ 972 2. An over-the-counter market for options traded on exchanges ............................. 976 3. The integration of trading of options and their" underlying securities in the over-the-counter markets__ 980 VI. The New York Stock Exchange and standardized options trading 983 A. The predominant position of the New York Stock Exchange in the markets for" underIying securities~_ ..... 987 1. NYSE market share ........... 987 2. NYSE financial resources .... 988 3. NYSE marketmaking resources_ 990 4. Additional NYSE resources 991 B. Potential NYSE p~edominance of the standardized options markets___ 994 1. NYSE and the primary market designation ..... 994 2. N YSE facilities advantage___ 995 3. N YSE advantage with respect to combined orders ...... 996 4. NYSE financial resources_ 997 5. NYSE marketmaking resources and advantages_ 999 6. NYSE 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~___ 103(3 2. Market linkage and order routing systems ...... 1044 3. Nationwide limit order protection 1046 4. Off-board trading restrictions 1049 Table 1--Call option classes which have been listed on two or more options exchanges .................................................... 1051 Table 2--Summary of price continuity data for call options multiply traded on CBOE and AMEX 1052 Table 3--Summary bid/ask spread data for call options multiply traded on the CBOE and AMEX ...................................... 1053 Table 4--Total contract volume for call options listed on both AMEX and CBOE ................................................... 1054 Table 5~Summary price continuity data for call options multiply traded on both a primary and secondary exchange 1055 Table 6--Summary bid/ask spread data for call options multiply traded on both a primary and Secondary exchange 1056 Table 7A--Weekly average variation in price per transaction for ])uPont Corp. call options on AMEX for the three months prior to and following initiation of multiple trading__ 1057 Table 7B--Weekly average variation in price per transaction for DuPont Corp. call options on CBOE for the three months following initiation of multiple trading ............................................. 1058 Table 8A--Weekly average bid/ask spread for DuPont Corp. call options on AMEX for the three months proir to and following initiation of multiple trading ............. 1059 Table 8B--Weekly average bid/ask spread for DuPont Corp. call options on CBOE for the three months following initiation of multiple trading_ 1060 Table 9A--Weekly average variation in price per transaction for Merrill Lynch call options on AMEX for the three months prior ~o and following initiation of multiple trading 1061

XXXV

Table 9B--Weekly average variation in price per transaction for Merrill Lynch call options on CBOE for the three months following initiation ~Page of multiple trading 1062 Table 10A--Weekly average bid/ask spread for Merrill Lynch call options on AMEX for the 3 months prior to the following initiation of multiple trading. 1063 Table 10B--Weekly average bid/ask spread for Merrill Lynch call options on CBOE for the 3 months following initiation of multiple trading___ 1064 Table llA--Summary price continuity and bid/ask spread information organized by size of option premium for Dupont Corporation ....... 1065 Table liB--Summary price continuity and bid/ask spread information organized by size of option premium from Burroughs Corporation___ 1067 Table llC--Summary p~iee continuity and bid/ask spread information organized by size of option premium for Digital Equipment Corporation .... 1069 Table 12--Exchange market share in options listed on both a primary and secondary exchange for selected clays from February 24, 1977 through August 31, 1977 ............................................... 1071 Table 13--Exchange market share in options listed on CBOE and AMEX for selected days from February 24, 1977 through August 31, 1977___ 1072 Table 14--Exchange market share in options which were multiply traded foi selected days from February 24, 1977 through August 31, 1977___ 1073 Table 15--Contract volume and market share of the CBOE and AMEX for August 1978 ............................................... 1074 Table 16--CBOE monthly contract volume and market share for American Express, Bally Mfg., Digital Equipment and National Semiconductor from 1/1/78 to 10/31/78__ !075 Table 17A--CBOE market share in national semiconductor__ 1076 Tat)le 17B--CBOE market share in digital equipment .................. 1077 Table 17C--CBOE market share in Bally ............................ 1078 Table 17D--CBOE market sharc in American Express ..... 1079 Table 18--Comparison of Bally Mfg. opening prices on AMEX and CBOE, September 1, 1978 ............................................. 1080 Table 19--Total options revenue for secondary exchanges and percentage of total exchange revenues ...................................... 1081 Table 20--Total options net income for secondary exchanges and percentage of total exchange net income .............................. 1081 Table 21--Total revenues derived from option transaction charges on secondary exchanges and percentage of total options revenues ....... 1081 Table 22--CBOE Table A: NYSE market share ..... 1082 Table 23--CBOE Table B: Distribution of market in certain common stocks selected and eligible fo~ exchange option trading 1083 Table 24--CBOE Table C: eompmative financial information for self;egulatory organizations (thousands of dollars) .................... 1084 Appendix Exhibits *: 1. Letter to George A. Fitzsimmons, Securities and Exchange Commission from James E. Buck, secretary, New York Stock Exchange dated September 22, 1978; and Letter" to George A. Fitzsimmons, Secretary, Secm’ities and Exchange Commission, from James E. Buck, secretary, New York Stock Exchange, dated November 29, 1978. 2. Letter" to George A. Fitzsimmons, Secretary, Securities and Exchange Commission, from Joseph W. Sullivan, president, Chicago Board Options Exchange, dated September 22, 1978. 3. Letter to George A. l~itzsimmons, Secretary, Securities and Exchange Commission, from Elkins Wctherill, president, Philadelphia Stock Exchange, (t~ted September 25, 1978. 4. Letter to George A. Fitzsimmons, Secretary, Securities and Exchange Commission, from Charles J. Henry, president, Pacific Stock Exchange, dated September 22, 1978. 5. Letter to George A. Fitzsimmons, Secretary, Securities and Exchange Commission, from Robert J. Birnbaum, president, American Stock Exchange, dated September 29, 1978. *These Appendix Exhibits are publicly available in the Commission’s Public Reference Room and, therefore arc not published as a part of th~s report.

XXXVI Appendix Exhibits: Continued 6. 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 Richard I. Weingarten, special counsel, Special Study of the Options Markets, from Joseph W. Sullivan, president, Chicago Board Options Exchange, dated October 11, 1978. 8. Pacific Stock Exchange Study comparing Pacific Stock Exchange and Chicago Board Options Exchange markets in Houston Oil and Minerals Corporation and Teledyne Corporation during December, 1976.