SEC Approves NASD Proposal To Raise Position Limits For Certain Equity Securities Not Subject To Standardized Options Trading

Executive Summary

On April 20, 1995, the Securities and Exchange Commission (SEC) approved an NASD^® proposal to amend Section 33(b)(3) of the NASD Rules of Fair Practice to increase the position and exercise limits for certain equity securities that are not subject to standardized options trading.¹ Specifically, with the amendment, if a security qualifies for a position limit of 7,500 contracts or 10,500 contracts, it will be subject to that higher position limit, regardless of whether it has standardized options traded on it or not.

Background And Description

Pursuant to Section 33(b)(3) of the NASD Rules of Fair Practice, position and exercise limits for exchange-listed options traded by access firms² or their customers are determined according to a "three-tiered" system, where, depending upon the float and trading volume of the underlying security, the position limit for options on that security is 4,500, 7,500, or 10,500 contracts.³ For conventional equity options trading by any NASD member,⁴ if the underlying security is subject to standardized options trading, the NASD's position limit for conventional options on that security is the same position limit imposed by the options exchange(s) trading the option. However, if the security underlying the option is not subject to standardized options trading, the applicable position limit for conventional options on the security is the lowest tier, that is, 4,500 contracts.

Thus, in the past, even though a security may have qualified for an options position limit of 10,500 or 7,500 contracts based on its public float and trading volume, it was subject to a position and exercise limit of 4,500 contracts because it did not underlie a standardized option. Because these securities qualified for higher position limits but were not eligible for them solely because there was no corresponding standardized option traded on them in the United States, NASD members' legitimate hedging activities were unduly constrained. Accordingly, the NASD proposed, and the SEC approved, an amendment to Section 33(b) that provides that the position limit for an option shall be determined by the position-limit tier the security falls under, regardless of whether the security is subject to standardized options trading. As with any other conventional equity option, if standardized options were subsequently listed on the stock, conventional options positions and standardized options positions overlying that stock would have to be aggregated.

Monitoring And Setting Position-Limit Procedures

Following are the procedures that the NASD will use to monitor and set position limits under the revised position-limit rule. These procedures only apply to the establishment of position limits for conventional options overlying securities not subject to standardized options trading.

Notifying Members Before Establishing Conventional Option Position

To ensure that the higher position limits for conventional options overlying securities not subject to standardized options trading are only available for securities qualifying for a position limit of 7,500 or 10,500 contracts, a member must demonstrate to the NASD Market Surveillance Department that the security satisfies the standards for such higher options position limit before establishing an unhedged options position on that security in excess of 4,500 contracts.⁵ The member must also demonstrate that the underlying security satisfies the initial listing standards for standardized options trading.⁶ Based on this information and after conducting its own review, the NASD will set a higher position limit for the stock or keep the position limit at 4,500 contracts. Thereafter, from the date the NASD establishes the original position limit until the Monday following the third Friday of the next January or July, whichever occurs first, the position limit applicable to that stock will remain the same for all other conventional options positions established on that stock.⁷

Monitoring Position-Limit Levels

In each successive January and July, the NASD will review the trading volume and float of each stock to determine if the applicable position limit should be raised, lowered, or left unchanged.⁸ Any changes to the position limits will become effective on the Monday following the third Friday of January or July.⁹ In addition, if the periodic review reveals that a position limit for a stock must be changed, each member that has an outstanding conventional option position on that stock will be notified of the change. If a position limit is lowered, while a firm (or its customer) will not be able to increase its conventional option position on that stock if its position is greater than the new limit, it will not be required to liquidate any pre-existing outstanding options position to a level equal to the new position limit. If a position limit is changed as a result of the six-month review, the position limit will remain at such new level until the next review.

In each successive January and July, the NASD also will review whether the underlying stock continues to meet the options exchanges' maintenance standards for standardized options trading.¹⁰ If a stock fails to meet the maintenance standards, the position limit will become 4,500 contracts effective on the Monday following the third Friday of January or July, regardless of whether the trading volume and float of the stock warrant a higher position limit. If the position limit is lowered, members (or their customers) will not have to liquidate pre-existing outstanding options positions to a level equal to 4,500 contracts.

NASD members and their customers who establish conventional options positions in reliance on the NASD's amended position-limit rule should be aware that they may be in technical violation of an options exchange's position-limit rule, should that exchange introduce standardized options on the same underlying security with a lower position limit subsequent to establishing the conventional options position.¹¹ While the NASD will most likely provide the market participant with a position-limit exemption in this instance and prohibit the investor from increasing its options position, there is the possibility that an options exchange may not also grant a corresponding exemption from its position-limit rule.

Questions regarding this Notice should be directed to Joseph Alotto, Regulatory Specialist, NASD Market Surveillance, at (301) 590-6845, or Thomas R. Gira, Assistant General Counsel, Office of General Counsel, at (202) 728-8957.

Text Of Amendments To Section 33(b)(3) Of The NASD Rules Of Fair Practice

(Note: New text is underlined.)

Section 33(b)(3) Position Limits

¹ Position limits impose a ceiling on the number of option contracts in each class on the same side of the market (that is, aggregating long calls and short puts and long puts and short calls) that can be held or written by an investor or group of investors acting in concert. Exercise limits restrict the number of options contracts that an investor or group of investors acting in concert can exercise within five consecutive business days. Under NASD rules, exercise limits correspond to position limits, such that investors in options classes on the same side of the market are allowed to exercise, during any five consecutive business days, only the number of options contracts set forth as the applicable position limit for those options classes. See Sections 33(b)(3) and (4) of the NASD Rules of Fair Practice.

² "Access" firms are NASD members that conduct a business in exchange-listed options, but are not members of any of the options exchanges upon which the options are listed and traded.

³ In this connection, NASD rules do not specifically govern how a specific equity option falls within one of the three position-limit tiers. Rather, the NASD's position-limit rule provides that the position limit established by an options exchange(s) for a particular equity option is the applicable position limit for purposes of NASD rules. Under the rules of the options exchanges, if the security underlying a standardized option has trading volume of 40 million shares over the most recent six months or trading volume of 30 million shares over the most recent six months and float of 120 million, it is subject to a position limit of 10,500 contracts; if the security underlying a standardized option has trading volume of 20 million shares over the most recent six months or trading volume of 15 million shares over the most recent six months and float of 40 million, it is subject to a position limit of 7,500 contracts; and, if the underlying security is ineligible for a 10,500 or 7,500 contract position limit, it is subject to a 4,500 contract position limit. See, Interpretation and Policy .02 to Chicago Board Options Exchange (CBOE) Rule 4.11.

⁴ Conventional equity options are defined in Section 33(b)(2)(GG) of the NASD Rules of Fair Practice as "any option contract not issued, or subject to issuance, by The Options Clearing Corporation."

⁵ For foreign securities, however, the NASD will not establish a position limit greater than 4,500 contracts (that is, 7,500 or 10,500 contracts) until: (1) it has in place a comprehensive surveillance sharing agreement with the primary exchange in the home country where the foreign security is primarily traded; or (2) the combined trading volume of the foreign security (and other related securities) occurring in the U.S. markets represents at least 50 percent of the combined world-wide trading volume in the underlying security (including other related securities).

⁶ The initial listing standards for standardized equity options provide that the underlying equity security must: (1) be listed on a national securities exchange or be a Nasdaq National Market^® security; (2) have a public float of at least 7 million shares; (3) have at least 2,000 shareholders; (4) have a trading volume of at least 2.4 million shares during the preceding 12 months; and (5) have a market price per share equal to or greater than $7.50 for the majority of the business days during the three preceding calendar months, as measured by the lowest closing price reported in any market in which the underlying security traded on each of the subject days. In addition, the issuer must be in compliance with any applicable requirement of the Securities Exchange Act of 1934. See, CBOE Rule 5.3.

⁷ For example, if the NASD determined that the position limit for stock XYZ was 10,500 contracts on March 1, 1995, the position limit would remain at 10,500 contracts until the Monday after the third Friday of July 1995.

⁸ In particular, the NASD will use data from July 1 through December 31 to review position-limit levels in January and data from January 1 to June 30 to review position-limit levels in July.

⁹ However, if subsequent to a six-month review, an increase in trading volume and/or outstanding shares would make such stock eligible for a higher position limit before the next review, the NASD, at its discretion, may increase immediately such position limit.

¹⁰ The maintenance listing standard for standardized equity options provides that the underlying security must have: (1) a public float of at least 6.3 million shares; (2) at least 1,600 shareholders; (3) trading volume of at least 1.8 million shares (in all markets in which the underlying security trades) during the preceding 12 months; and (4) a market price per share equal to or greater than $5 on a majority of the business days during the preceding six calendar months, as measured by the highest closing price reported in any market in which the security traded (basic maintenance standards). However, a stock will continue to meet the maintenance listing standards for an additional six months if it had: (1) a market value of at least $50 million; (2) trading volume of at least 2.4 million shares during the preceding 12 months; (3) a market price per share of $3 or more on a majority of the business days during the preceding six calendar months, as measured by the highest closing price reported in any market in which the security traded; and (4) the market price per share is at least $3 at the time of the review (alternative maintenance standard). Thereafter, if the stock did not satisfy the basic maintenance standards at the next six-month review, it would only retain a position limit greater than 4,500 contracts if it satisfied the alternative maintenance standard using a maintenance price of $4 instead of $3. For subsequent reviews, the stock will have to satisfy the basic maintenance standards. See, CBOE Rule 5.4.

¹¹ For example, a market participant may establish a conventional options position of 10,500 contracts on a stock in February 1996 pursuant to the NASD proposal, and thereafter an options exchange may choose to list options on the stock on May 1, 1996, with a position limit of 7,500 contracts. In this case, the trading volume and/or float of the stock would have declined since February, such that the stock was no longer eligible for the 10,500 contract position limit. Assuming the options exchange takes the position that standardized and conventional options positions must be aggregated for position-limit purposes, the market participant would be in violation of the options exchange's position-limit rule because its conventional options position would be 3,000 contracts in excess of the 7,500-contract-position limit.

¹ In order for a security not subject to standardized options trading to be eligible for a higher options position limit of 7,500 or 10,500 contracts, a member must first demonstrate to the NASD Market Surveillance Department that the security meets the standards for such higher options position limit and the initial listing standards for standardized options trading