Executive Summary Background And Discussion NASD On June 12, 1998, the Securities and NASD Rule 2860 governs members’ Exchange Commission (SEC) activities in standardized, convention- approved amendments to National al, and FLEX equity options. Stan- Notice to Association of Securities Dealers, dardized options are exchange-traded Inc. (NASD¨) Rule 2860 and Inter- options issued by the Options Clear- pretive Material 2860-1 (IM-2860-1). ing Corporation (OCC) that have Members The amendments to Rule 2860 make standardized terms for strike prices, three basic changes. First, the dates, and the amount of 98-49 amendments increase the the . Convention- limits on conventional equity options al options are any other options con- to the greater of three times the basic tracts not issued, or subject to limit of 4,500 contracts, or three issuance, by the OCC. Conventional times any standardized equity options are also frequently referred to SEC Approves options position limit for which the as over-the-counter (OTC) options. Amendments To Rule underlying security qualifies or would FLEX equity options are exchange- Regarding Options be able to qualify. Second, the traded options issued by the OCC Position Limits; Effective amendments disaggregate conven- that give the ability, within tional equity options from standard- specified limits, to designate certain June 12, 1998 ized equity options and FLEX equity terms of the (i.e., the options for position limit purposes, price, exercise style, expiration date, i.e., standardized and FLEX equity or option type). option positions do not count towards Suggested Routing the position limits for conventional NASD Rule 2860(b)(3) imposes a Senior Management equity options on the same underly- ceiling or position limit on the number ing security. Third, the amendments of conventional and standardized Advertising provide that the OTC Aggrega- equity options contracts in each class Continuing Education tion Exemption shall be available on the same side of the (i.e., with respect to an entire conventional aggregating calls and puts equity options position, not just that or long puts and short calls) that can Executive Representatives portion of the position that is estab- be held or written by a member, a Government Securities lished pursuant to the NASD’s Equity person associated with a member, a Option Exemption (Hedge customer, or a group of customers Institutional Exemption). In addition, the amend- acting in concert. The position limits Insurance ments to IM-2860-1 clarify and for equity options are established Internal Audit update the illustrative examples to be according to a five-tiered system consistent with the new amendments whereby more actively traded securi- Legal & Compliance and prior increases in the Hedge ties with larger public floats are sub- Municipal Exemption. The amendments ject to higher position limits and less became effective on June 12, 1998. actively traded are subject to Mutual Fund The text of the amended rules and lower limits. The current tiers for Operations the Federal Register version of the standardized equity options are Options SEC Release are attached. See 63 4,500, 7,500, 10,500, 20,000, and FR 33746 (June 19, 1998). 25,000 options contracts.1 The Registered Representatives NASD rules do not specifically gov- Registration Questions concerning this Notice ern whether a particular equity option Research should be directed to Gary L. Gold- falls within one of the position-limit sholle, Assistant General Counsel, tiers. Rather, the NASD position limit Syndicate Office of General Counsel, NASD rule generally provides that the posi- Systems Regulation, Inc., at (202) 728-8104. tion limit established by an options exchange(s) for a particular equity Trading option is the applicable position limit Training for purposes of the NASD rule. Variable Contracts

NASD Notice to Members 98-49 July 1998 377 On September 9, 1997, the Commis- To illustrate how these new limits OTC Collar Aggregation Exemption, sion approved a two-year pilot pro- work, consider the following example i.e., that if the terms of the exemption gram to eliminate position and of ABCD, which is subject to a are met, the segments of an OTC exercise limits for FLEX equity position limit of 25,000 standardized collar will never both be in-the- options, which are traded on the vari- equity option contracts. In this exam- money at the same time or exer- ous options exchanges.2 In light of ple, a market participant could estab- cised. the pilot program, NASD RegulationSM lish a position of 25,000 standardized amended its rules governing position option contracts on ABCD and an To illustrate how these new provi- and exercise limits for conventional additional 75,000 conventional option sions work, consider the following equity options to foster competition contracts on ABCD on the same side example of stock ABCD that is sub- between the OTC market and the of the market, since conventional ject to a standardized equity option options exchanges. and standardized option positions position limit of 25,000 contracts and would be disaggregated. In addition, a conventional equity option position NASD Regulation believes that the market participant also may have limit of 75,000 contracts. If the mar- FLEX equity options closely resem- a position of any size in FLEX Equity ket participant had increased the size ble and are economically equivalent Options overlying ABCD, since such of its conventional equity options to conventional equity options. FLEX equity options would not be position to 225,000 pursuant to the Accordingly, the amendments to aggregated with either the conven- Hedge Exemption (based upon a Rule 2860(b)(3) seek to more closely tional equity options or standardized limit of three times the 75,000 con- align the NASD’s position limit rules equity options overlying ABCD. ventional equity options position for conventional equity options with limit), the market participant could those for FLEX equity options. In The NASD’s Hedge Exemption3 pro- then establish an OTC collar on fact, the new limits on conventional vides for an automatic exemption ABCD involving 225,000 long (short) equity options correspond to the from equity option position limits for calls and 225,000 short (long) puts, position limits that were in effect for accounts that have established for a total of 450,000 contracts. FLEX equity options prior to the elim- hedged positions on a limited one- ination of such limits in the pilot pro- for-one basis (i.e., 100 shares of Finally, members are reminded that gram. Under the new amendments, stock for one option contract). Under Rule 2860(b)(5) imposes reporting the position limits for conventional the Hedge Exemption, the largest obligations on “each account in equity options have increased to the options position that may be estab- which the member has an interest . . . greater of three times the basic limit lished (combining hedged and and each customer account, which of 4,500 contracts, or three times any unhedged positions) may not exceed has established an aggregate posi- higher standardized equity options three times the basic position limits tion of 200 or more option contracts position limit for which the underlying for either standardized or conven- (whether long or short) of the put security qualifies or would be able to tional equity options. The OTC Col- class and the call class on the same qualify. lar Aggregation Exemption4 provides side of the market covering the same that positions in conventional put and underlying security.” Information The new amendments also provide call options establishing OTC collars reported to the NASD is used by that conventional equity options posi- need not be aggregated for position NASD Regulation Market Regulation tions shall not be aggregated with limit purposes. An OTC collar trans- staff as part of their ongoing market standardized and FLEX equity action involves the purchase (sale) of surveillance operations. Additional options positions overlying the same a put and the sale (purchase) of a information concerning members’ security for position limit purposes. call on the same underlying security options reporting obligations may be Disaggregation of conventional and to hedge a long (short) stock posi- found in Notice to Members 94-46. other options is necessary to give full tion. effect to the increase in position lim- its for conventional equity options. The new amendments modify the Without disaggregation, positions in terms of the OTC Collar Aggregation FLEX equity options or standardized Exemption to apply to an entire con- equity options would reduce or ventional equity option position, not potentially even eliminate (in the just the portion that is established case of FLEX equity options) the pursuant to the Hedge Exemption. available position limits for conven- This amendment is consistent with tional equity options. the economic logic underlying the

NASD Notice to Members 98-49 July 1998 378 Text Of Rule Amendments class and the call class on the same applicable rules for a position limit of (Note: New text is underlined; deletions are side of the market covering the same 25,000 option contracts; or bracketed.) underlying security, combining for purposes of this position limit long (vi) such other number of stock Rule 2860. Options positions in put options with short options contracts as may be fixed positions in call options, and short from time to time by the Association (a) No Change positions in put options with long as the position limit for one or more positions in call options; or classes or series of options provided (b) Requirements that reasonable notice shall be given (ii) 7,500 options contracts of the put of each new position limit fixed by (2) Definitions class and the call class on the same the Association. side of the market covering the same The following terms shall, unless the underlying security, providing that the (vii) Equity Option Hedge Exemption context otherwise requires, have the 7,500 contract position limit shall only stated meanings: be available for option contracts on a. The following positions, where securities which underlie [or qualify each option contract is “hedged” by (A) - (UU) No Change to underlie] or exchange- 100 shares of stock or securities traded options qualifying under appli- readily convertible into or economi- (VV) Standardized Equity Option— cable rules for a position limit of cally equivalent to such stock, or, in The term “standardized equity option” 7,500 option contracts; or the case of an adjusted option con- means any equity options contract tract, the same number of shares issued, or subject to issuance by, The (iii) 10,500 option contracts of the put represented by the adjusted contract, Options Corporation that is class and the call class on the same shall be exempted from established not a FLEX Equity Option. side of the market covering the same limits contained in subparagraph underlying security providing that the (b)(3)(A)(i) through (vi) above: (WW) - (AAA) Redesignated accord- 10,500 contract position limit shall ingly. only be available for option contracts 1. long call and short stock; on securities which underlie [or quali- (3) Position Limits fy to underlie] Nasdaq or exchange- 2. short call and long stock; traded options qualifying under (A) Stock Options—Except in highly applicable rules for a position limit of 3. long put and long stock; unusual circumstances and with the 10,500 option contracts; or prior written approval of the Associa- 4. short put and short stock. tion in each instance, no member (iv) 20,000 options contracts of the shall effect for any account in which put and the call class on the same b. Except as provided [under] in such member has an interest, or for side of the market covering the same paragraph (b)(3)(A)(ix) and in the the account of any partner, officer, underlying security, providing that the OTC Collar Exemption contained in director or employee thereof, or for 20,000 contract position limit shall paragraph (b)(3)(A)(viii), in no event the account of any customer, an only be available for option contracts may the maximum allowable posi- opening transaction through Nasdaq, on securities which underlie [or quali- tion, inclusive of options contracts the over-the-counter market or on fy to underlie] Nasdaq or exchange- hedged pursuant to the equity option any exchange in a stock option con- traded options qualifying under position limit hedge exemption in tract of any class of stock options if applicable rules for a position limit of subparagraph a. above, exceed the member has reason to believe 20,000 option contracts; or three times the applicable position that as a result of such transaction limit established in subparagraphs the member or partner, officer, direc- (v) 25,000 options contracts of the (b)(3)(A)(i)[-] through (v) with respect tor or employee thereof, or customer put and the call class on the same to standardized equity options, or would, acting alone or in concert with side of the market covering the same paragraph (b)(3)(A)(ix) with respect others, directly or indirectly, hold or underlying security, providing that the to conventional equity options. control or be obligated in respect of 25,000 contract position limit shall an aggregate equity options position only be available for option contracts c. The Equity Option Hedge Exemp- in excess of: on securities which underlie [or quali- tion is a pilot program authorized by fy to underlie] Nasdaq or exchange- the Commission through December (i) 4,500 option contracts of the put traded options qualifying under 31, 1998.

NASD Notice to Members 98-49 July 1998 379 (viii) OTC Collar Aggregation Exemp- the requisite long or short stock posi- 2. three times any standardized equi- tion tion for the duration of the collar, ty options position limit as set forth in although the same long or short subparagraphs (b)(3)(A)(ii) through a. For purposes of this paragraph stock position can be used to hedge (v) for which the underlying security (b), the term OTC collar shall mean a both legs of the collar. qualifies or would be able to qualify. conventional equity option position comprised of short (long) calls and c. For multiple OTC collars on the b. In order for a security not subject long (short) puts overlying the same same security meeting the conditions to standardized equity options trad- security that hedge a corresponding set forth in subparagraph b. above, ing to qualify for an options position long (short) position in that security. all of the short (long) call options that limit of more than 4,500 contracts, a are part of such collars must be member must first demonstrate to b. Notwithstanding the aggregation aggregated and all of the long (short) the Association’s Market Regulation provisions for short (long) call posi- put options that are part of such col- Department that the underlying secu- tions and long (short) put positions lars must be aggregated, but the rity meets the standards for such contained in subparagraphs short (long) calls need not be aggre- higher options position limit and the (b)(3)(A)(i) through (v) above, the gated with the long (short) puts. initial listing standards for standard- conventional options positions ized options trading. involved in a particular OTC collar d. Except as provided above in sub- transaction [established pursuant to paragraphs b. and c., in no event (footnotes deleted) the position limit hedge exemption in may a member fail to aggregate any subparagraph (vii)] need not be conventional [or standardized] IM-2860-1. Position Limits aggregated for position limit purpos- options contract of the put class and es, provided the following conditions the call class overlying the same The following examples illustrate the are satisfied: equity security on the same side of operation of position limits estab- the market with conventional option lished by Rule 2860(b)(3) (all exam- 1. the conventional options can only positions established in connection ples assume a position limit of 4,500 be exercised if they are in-the- with an OTC collar. contracts and that the options are money; standardized options): e. Nothing in this paragraph 2. neither conventional option can be (b)(3)(A)(viii) changes the applicable (a) Customer A, who is long 4,500 sold, assigned, or transferred by the position limit for a particular equity XYZ calls, may at the same time be holder without the prior written con- security. short 4,500 XYZ calls, since long and sent of the writer; short positions in the same class of (ix) Conventional Equity Options options (i.e., in calls only, or in puts 3. the conventional options must be only) are on opposite sides of the European-style (i.e., only exercisable a. For purposes of this paragraph market and are not aggregated for upon expiration) and expire on the (b), standardized equity options con- purposes of paragraph (b)(3). same date; tracts of the put class and call class on the same side of the market over- (b) Customer B, who is long 4,500 4. the of the short call can lying the same security shall not be XYZ calls, may at the same time be never be less than the strike price of aggregated with conventional equity long 4,500 XYZ puts. Paragraph the long put; and options contracts or FLEX Equity (b)(3) does not require the aggrega- Options contracts overlying the same tion of long call and long put (or short 5. neither side of any particular OTC security on the same side of the mar- call and short put) positions, since collar transaction can be in-the- ket. Conventional equity options they are on opposite sides of the money when that particular OTC col- contracts of the put class and call market. lar is established. class on the same side of the market overlying the same security shall be (c) Customer C, who is long 1,700 6. the size of the conventional subject to a position limit equal to the XYZ calls, may not at the same time options in excess of the applicable greater of: be short more than 2,800 XYZ puts, basic position limit for the options since the 4,500 contract limit applies established pursuant to paragraph 1. three times the basic limit of 4,500 to the aggregation of long call and (b)(3)(A)(ix) [(A)(i)-(v) above] must be contracts, or short put positions in options cover- hedged on a one-to-one basis with ing the same underlying security.

NASD Notice to Members 98-49 July 1998 380 Similarly, if Customer C is also short 13,500 [9,000] contracts in size. In ing position limits on FLEX equity options 1,600 XYZ calls, he may not at the this instance, 4,500 of the 13,500 traded on the American , the same time be long more than 2,900 [9,000] contracts are permissible Chicago Board Options Exchange and the puts, since the 4,500 contract limit under the basic position limit con- Pacific Exchange); see also 63 FR 14743 applies separately to the aggregation tained in paragraph (b)(3)(A)(i) and (March 26, 1998) (amending NASD rules to of short call and long put positions in the remaining 9,000 [4,500] contracts eliminate position limits on FLEX equity options covering the same underly- are permissible because they are options, consistent with the pilot program). ing security. hedged by the 900,000 [450,000] short stock position. 3 Rule 2860(b)(3)(A)(vii). (d) Customer D, who is short 900,000 [450,000] shares of XYZ, Endnotes 4 Rule 2860(b)(3)(A)(viii). may be long up to 13,500 [9,000] XYZ calls, since the “hedge” exemp- 1 Rule 2860(b)(3)(A)(i) through (v). © 1998, National Association of Securities Dealers, tion contained in paragraph Inc. (NASD). All rights reserved. (b)(3)(A)(vii) permits Customer D to 2 See 62 FR 48683 (September 16, 1997) establish an options position up to (approving two-year pilot program eliminat-

NASD Notice to Members 98-49 July 1998 381