Self-Regulatory Organizations; Chicago Board Options Exchange, Incorporated; Order Approving a Proposed Rule Change To Adopt Rules Governing S&P 500 Option Variance Basket Trades, 5286-5289 [2012-2237]
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Federal Register / Vol. 77, No. 22 / Thursday, February 2, 2012 / Notices
SECURITIES AND EXCHANGE
COMMISSION
[Release No. 34–66265; File No. SR–CBOE–
2011–007]
Self-Regulatory Organizations;
Chicago Board Options Exchange,
Incorporated; Order Approving a
Proposed Rule Change To Adopt Rules
Governing S&P 500 Option Variance
Basket Trades
January 27, 2012.
I. Introduction
On October 26, 2011, Chicago Board
Options Exchange, Incorporated
(‘‘Exchange’’ or ‘‘CBOE’’) filed with the
Securities and Exchange Commission
(‘‘Commission’’), pursuant to Section
19(b)(1) of the Securities Exchange Act
of 1934 (‘‘Act’’) 1 and Rule 19b–4
thereunder,2 a proposed rule change to
adopt rules in connection with a
mechanism to quote for, and trade, at a
single aggregate price, a basket of S&P
500 Index Options comprising a prespecified series of listed calls and puts
that are constructed to assist market
participants who use such baskets of
options as part of a trading strategy to
obtain or hedge variance exposure on
the S&P 500 Index. The proposed rule
change was published for comment in
the Federal Register on November 16,
2011.3 The Commission received one
comment letter on the proposed rule
change.4 This order approves the
proposed rule change.
II. Description of the Proposed Rule
Change
The Exchange is proposing a new
offering, called S&P 500 Variance
Trades (‘‘Variance Trades’’), which will
allow market participants to trade a
basket of pre-specified series of S&P 500
Index options (‘‘SPX options’’) in a
single transaction. Each pre-specified
basket of series of options offered by the
Exchange will be constructed using a
methodology designed to produce
options baskets that can be used by
market participants as part of a trading
strategy to obtain or hedge variance
exposure on the S&P 500 Index.5
1 15
U.S.C. 78s(b)(1).
CFR 240.19b–4.
3 See Securities Exchange Act Release No. 65725
(November 10, 2011), 76 FR 71092 (‘‘Notice’’).
4 See Letter dated December 14, 2011, from
Angelo Evangelou, Assistant General Counsel, Legal
Division, CBOE, to Elizabeth M. Murphy, Secretary,
Commission (‘‘CBOE Letter’’).
5 The Exchange notes that Variance Trades do not
replicate variance swaps. See Notice, supra note 3,
76 FR 71092, n.4. The Commission understands
that Variance Trades could be useful to market
participants who employ trading strategies to hedge
or replicate variance swaps on the S&P 500 Index.
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Currently, a trader would need to
separately purchase or sell each of the
options in a pre-specified Variance
Trade basket to acquire this type of
options exposure. In its filing, the
Exchange notes that demand for
volatility products has increased in
recent years, and believes that the
proposed Variance Trades would
provide investors with an additional
way to efficiently trade S&P 500
volatility.6
A Variance Trade consists of a basket
of SPX options across different series,
where the constituent options of the
basket are put and call options with the
same expiration date that are centered
around an at-the-money strike price.7
The Exchange will make one or more
Variance Trade baskets available for
trading each day. Each basket will
consist of a portfolio of SPX options
defined by the Exchange the day before
it is available for trading. Each basket
will have a unique ticker symbol.
Unlike a typical multi-legged option
transaction whose price is expressed as
a net dollar price, the price of a
Variance Trade will be quoted in
‘‘volatility terms’’ (i.e., a single number
that reflects an aggregate implied
volatility for the entire options basket).
Trade quantities will be expressed in
contracts, and each contract will have a
multiplier of $10,000 or more, as
determined and announced by the
Exchange in advance.8 The Exchange
expects typically to specify a higher
multiplier than $10,000, but has
proposed to establish a $10,000
minimum to allow greater flexibility for
short-dated options and low volatility
levels.9
A participant will submit a Variance
Trade order with a limit price expressed
in terms of volatility (market orders
would not be permitted) and a contract
size.10 Market makers also will be
allowed to provide quotes for Variance
Trade baskets. Orders and quotes will be
ranked pursuant to one of the matching
algorithms set forth in CBOE Rule
A variance swap is a derivative in which two
counterparties agree to exchange future cash flows
based on the realized level of volatility of a tradable
financial instrument over a pre-specified, future
period of time.
6 See Notice, supra note 3, 76 FR 71092, text
accompanying n.4. See also CBOE Letter, supra
note 4, at 3.
7 Detailed examples of how Variance Trades
would be constructed and executed on the
Exchange are provided in the Notice. See Notice,
supra note 3.
8 The multiplier for Variance Trades represents
the aggregate ‘‘vega’’ exposure of the SPX option
series that comprise the Variance Trade portfolio.
Vega describes the change in value of a contract
corresponding to a one-point change in volatility.
9 See Notice, supra note 3, at n.6.
10 Variance Trades will trade only electronically.
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6.45A, which may be different from the
matching algorithm in place for other
option products, including SPX. Once a
Variance Trade match occurs, the
Exchange will use a formula to
deconstruct the trade into individual
trades in the constituent SPX options
that compose the basket, and those
individual trades each will be sent to
OPRA as separate trades.11
The algorithm that deconstructs a
Variance Trade into its constituent SPX
option legs uses a two step process.
First, based on the matched implied
volatility (i.e., the price of the trade), the
system will calculate the exact number
of contracts for each SPX option series
composing the Variance Trade.12
Second, the system will calculate
resulting trade prices for each SPX
option series through an iterative
process in which current implied
volatilities for each option series are
collectively adjusted upwards or
downwards until the aggregate implied
volatility of the overall basket equals the
matched implied volatility as quoted.
The individual price of any given option
series in the basket generally would not
be the same as (or directly related to) the
prevailing market price for that series
because the entire basket will be priced
in the aggregate in order to reflect the
desired volatility level.
The Exchange’s proposal will allow
the constituent SPX option trades of a
Variance Trade to be executed and
reported without regard to existing bids
and offers on the Exchange in the
individual SPX options series at the
time of the transaction.13 Once prices
are determined for a trade in each
constituent series, the system will
execute and report the constituent
trades to OPRA.14 In addition, the
executions in the individual constituent
series will be sent to the Options
11 See Notice, supra note 3, 76 FR 71093 (setting
forth the formula).
12 Unlike a typical complex order, the terms of a
Variance Trade order would not pre-specify the
number of contracts for each individual series
composing the trade. These quantities instead
depend on the implied volatility of the options
basket itself, which is not known until a matched
implied volatility for a trade has been determined.
13 See Notice, supra note 3, 76 FR 71093.
14 To highlight that executions of Variance Trades
are not associated with the quoted prices in the
respective SPX series at the time of execution, each
constituent SPX option execution will be reported
to OPRA with the ‘‘benchmark’’ indicator. The
benchmark indicator was created to facilitate the
execution of benchmark orders as contemplated by
the Options Order Protection and Locked/Crossed
Market Plan (the ‘‘Linkage Plan’’). A benchmark
order is an order for which the price is not based,
directly or indirectly, on the quoted price of the
option at the time of the order’s execution and for
which the material terms were not reasonably
determinable at the time a commitment to trade the
order was made.
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Federal Register / Vol. 77, No. 22 / Thursday, February 2, 2012 / Notices
Clearing Corporation (‘‘OCC’’) for
clearing.
As there are no position limits for
SPX options, the Exchange did not
propose any position limits for
executions associated with Variance
Trades. Reporting limits applicable to
SPX options will apply pursuant to
CBOE Rule 24.4, Interpretation and
Policy .03.
The Exchange expects Variance
Trades to appeal to institutional users
and not to retail customers.15 Because of
the complex nature of Variance Trades,
the Exchange will only allow orders in
Variance Trades to be submitted by
members who have affirmatively
communicated to the Exchange a desire
to submit orders in Variance Trades.
Thus, retail brokerage firms (or any
other firms) that have not specifically
opted to submit orders in Variance
Trades will not be allowed to send such
orders to CBOE (any such orders from
such firms will be rejected).
The Exchange represents that
appropriate surveillance will be in place
in connection with Variance Trades.16
Further, the Exchange states that it has
analyzed its capacity and represents that
it and the Options Price Reporting
Authority have the necessary systems
capacity to handle the additional traffic
that it expects will be associated with
Variance Trades.17
III. Discussion and Commission’s
Findings
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After careful review, the Commission
finds that the proposed rule change is
consistent with the requirements of
Section 6 of the Act 18 and the rules and
regulations thereunder applicable to a
national securities exchange.19 In
particular, the Commission finds that
the proposed rule change is consistent
with Section 6(b)(5) of the Act,20 which
requires, among other things, that the
Exchange’s rules be designed to prevent
fraudulent and manipulative acts and
practices, to promote just and equitable
principles of trade, to foster cooperation
and coordination with persons engaged
in facilitating transactions in securities,
to remove impediments to and perfect
the mechanism of a free and open
market and a national market system,
and, in general, to protect investors and
the public interest.
15 See
id. at 71101.
id.
17 See id.
18 15 U.S.C. 78f.
19 In approving this proposed rule change, the
Commission has considered the proposed rule’s
impact on efficiency, competition, and capital
formation. See 15 U.S.C. 78c(f).
20 15 U.S.C. 78f(b)(5).
16 See
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The introduction of Variance Trades
is designed to allow professional market
participants to more efficiently trade an
entire option portfolio to obtain or
hedge variance exposure on the S&P 500
Index. Such traders otherwise would
need to purchase or sell each option
individually to acquire exposure to such
a basket of options in a complex web of
simultaneously-executed transactions
that is very difficult to reproduce as a
series of individual trades. To the extent
that traders currently seek out similar
products offered on the over-the-counter
securities markets, the proposed rule
change will permit them to trade
Variance Trades on a registered national
securities exchange. The Commission
believes that the proposal will benefit
participants by providing an alternative
to the over-the-counter market through
the functionality to trade these baskets
of exchange-listed options in a national
securities exchange environment that
offers the potential of enhanced
liquidity, transparency, and oversight,
and where counterparty risk can be
mitigated through the role of OCC.
Moreover, the requirement that permit
holders affirmatively indicate to the
Exchange a desire to transact in
Variance Trades before the Exchange
accepts and processes orders from such
firms will serve as an additional
safeguard to protect against the
inadvertent submission of Variance
Trade orders.
In the Notice, the Commission sought
comment on two particular issues
relating to the proposed Variance
Trades: (1) Allowing the constituent
SPX option trades of a Variance Trade
to be executed and reported without
regard to existing bids and offers on the
Exchange in SPX at the time of the
transaction; and (2) use of the
benchmark indicator when reporting the
constituent legs of a Variance Trade.21
CBOE submitted a letter in response to
the Commission’s request for comments,
urging the Commission to approve its
proposal.22 The Commission did not
receive any other comments.
On the first point, the Commission
requested commenters’ opinions on
whether allowing the constituent SPX
option legs of a Variance Trade to be
executed and reported without regard
for existing bids and offers on the
Exchange in SPX at the time of the
transaction would be consistent with
the Exchange Act and what, if any,
potential impact this proposal might
have on market participants.23 As noted
21 See
Notice, supra note 3, 76 FR 71102.
CBOE Letter, supra note 4.
23 See Notice, supra note 3, 76 FR 71102.
22 See
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above, the Commission received no
comments except from CBOE.
While multi-leg complex orders can
trade on CBOE at the same price as
existing booked interest on CBOE for
one or more legs only if they improve
the price on another leg,24 Variance
Trades will have no similar restrictions,
and the constituent legs could thus
trade without regard to quotes and
orders with priority on CBOE’s book.25
Exceptions from intra-market priority
can raise concerns relating to the
protection of resting quotes and orders
on an exchange’s book and the potential
impact on the price discovery process.26
In its letter, the Exchange argues that
orders and quotes in individual SPX
options series would not be
disadvantaged when the various legs of
a deconstructed Variance Trade execute,
because traders in the individual SPX
option series are not bidding for or
offering the entire Variance Trade,
which is the relevant order being
executed.27 While true, that argument is
inconsistent with the treatment of other
complex orders, noted above, which are
required to interact with resting orders
with priority except under limited
circumstances.
In addition, CBOE believes that
requiring the deconstructed components
of a Variance Trade to interact with
orders resting on the CBOE’s SPX book
would impede and frustrate traders’
desire to enter into Variance Trades and
achieve their investment objectives.28
Rather, CBOE argues that introducing an
exchange-traded functionality that
allows investors to place a single order
expressed in volatility terms and that
permits those investors to establish a
specific volatility profile is consistent
with Section 6(b)(5) of the Act in that it
removes impediments to, and perfects
the mechanism for, a free and open
market.29 The Exchange asserts that if
some constituent trades were required
to be executed separately from the
Variance Trade it would materially alter
the pricing of the Variance Trade as well
as its variance exposure, and would
require the investor to execute separate
trades in one or more constituent SPX
options in an attempt to achieve the
24 See
CBOE Rule 6.45(B)(b)(ii).
SPX options are singly-listed on CBOE,
and because the only components of a Variance
Trade will be SPX options, CBOE’s proposal does
not implicate inter-market order protection
concerns.
26 See e.g.,Securities Exchange Act Release No.
63955 (February 24, 2011), 76 FR 11533, at 11540
(March 2, 2011) (SR–ISE–2010–73).
27 See CBOE Letter, supra note 4, at 2.
28 See id. at 3.
29 See id.
25 Because
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objective variance exposure.30 The
Exchange also states that requiring that
positions in the individual constituent
series be assigned different prices than
those assigned by the algorithm would
mean that either the Variance Trade
execution price must be modified or a
different and less efficient algorithm
would be required to assign prices to
certain constituent SPX options to reach
the trade’s stated execution price.31 The
Exchange believes both alternatives
would destroy the appeal of the
Variance Trade process.32 According to
the Exchange, its proposal is narrowly
crafted to prevent abuse and would
facilitate beneficial volatility trading
and hedging activity that would serve
the needs of the marketplace.33
Further, CBOE argues that the prices
of the constituent option series are
unrelated to quotes and orders on
CBOE’s book and that requiring the
constituent legs of a Variance Trade to
interact with the book could introduce
inefficiencies in the pricing of Variance
Trades.34 The Commission notes that
the fact that a given trade in a
constituent option series may trade
through the price of resting interest is a
consequence of the Variance Trade
methodology and the fact that a
Variance Trade is priced not in net
dollar terms but in volatility terms.
Unlike complex orders (as defined in
CBOE’s rules),35 the terms of a Variance
Trade order would not pre-specify a
quantity for each individual series.
Rather, since the exact size (number of
contracts) in each constituent series is a
function of the matched implied
volatility, it can only be computed once
a match has occurred. In addition, the
trade prices of the individual legs are
derived simultaneously using a complex
iterative process that is conducted after
a match has occurred.
Requiring the component legs of a
Variance Trade basket to interact with
resting orders in CBOE’s SPX book
would materially alter the computed
prices for each component leg and
therein would frustrate the ability of
30 See
id. at 4.
id.
32 See id.
33 See id.
34 See id. The Commission notes that despite
CBOE’s assertion that the prices of the constituent
option series of a Variance Trade would be
unrelated to quotes and orders on CBOE’s book, the
proposed methodology CBOE would use for
determining option prices in connection with
Variance Trades starts with the actual quoted
option prices themselves and then adjusts them
upwards or downwards as needed. Thus, the price
of each option leg of a Variance Trade actually
would take into account the market price of each
series.
35 See CBOE Rule 6.53C.
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participants to consummate such
transactions and undermine the
objective of the trade. Specifically, the
Variance Trade algorithm calculates a
series of contract sizes and prices that
span a considerable number of series
and the interaction of these trades with
resting orders would impact that
process to an extent that could make it
difficult, if not impossible, to
consummate a Variance Trade
transaction. Accordingly, in light of the
unique structure and calculation
methodology of the Variance Trade, as
discussed more fully above, the
Commission believes that allowing
Variance Trades to execute without
interacting with pre-existing interest on
CBOE is appropriate and consistent
with the Act.
The second point on which the
Commission requested comment in the
Notice relates to the use of the
benchmark trade reporting indicator
when reporting the constituent legs of a
Variance Trade. The Exchange’s
proposal seeks to use the ‘‘benchmark’’
indicator for informational purposes
when reporting executions of the
constituent legs of a Variance Trade
transaction, even though such trades
would not be ‘‘benchmark’’ trades
pursuant to Section 5(b)(xi) of the
Linkage Plan, which by its terms applies
only to inter-market (not intra-market)
order protection.36 The Commission
received no comments except from
CBOE.
The Exchange believes that the
benchmark indicator, while it was
created for the reporting of multiplylisted option executions, nevertheless
would be useful to append to the
execution of constituent series of a
Variance Trade so SPX traders know
that the executions were not related to
the quoted price at the time of the
print.37 In its letter, the Exchange argues
that the rationale behind the benchmark
indicator also applies to Variance
Trades.38 Specifically, the Exchange
believes that the constituent SPX
options executions clearly fall within
the definition of a benchmark trade in
that they are not related to the quoted
SPX prices at the time of execution,
which is how the benchmark indicator
36 A benchmark order is an order for which the
price is not based, directly or indirectly, on the
quoted price of the option at the time of the order’s
execution and for which the material terms were
not reasonably determinable at the time a
commitment to trade the order was made. See
CBOE Rule 6.81(b)(10) and Section 5(b)(xi) of the
Linkage Plan.
37 Currently, CBOE does not offer functionality or
order types that utilize the benchmark exception to
the Linkage Plan. See Notice, supra note 3, 76 FR
71093, n.7.
38 CBOE Letter, supra note 4, at 3.
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would be used in the context of
multiply-listed options.39 Further,
CBOE believes that the fact that SPX
options only trade on CBOE should not
alter the conclusion that benchmark
trades be exempt from certain priority
considerations because they utilize
transparent pricing methods that do not
take into account the quoted market in
the applicable security.40 The Exchange
believes that the proposed use of the
benchmark trade indicator would
appropriately alert SPX market
participants that the prices of the
executed SPX constituent trades were
not related to the quoted SPX prices at
the time of the execution, in a way that
would avoid any market confusion. The
Exchange also believes that it would
facilitate its surveillance of the
constituent trades.41
The Commission believes that the use
of an indicator for the trades in the
constituent series of a Variance Trade is
appropriate to alert market participants
that the executions are not regular
market transactions in order to guard
against investor confusion in seeing
individual options trade at prices that
may be above or below prevailing
market prices.
CBOE has informed the Commission
that, at the present time, the benchmark
indicator is not used in the options
markets.42 In reliance on this
representation, the Commission believes
the potential for investor confusion by
marking the constituent trades as
benchmark trades would be minimal,
and that the use of the benchmark
indicator for these purposes is
reasonable at this time. The Commission
notes, however, that use of another
indicator may be preferable given that
the benchmark indicator was intended
for use in the context of inter-market
order protection and therefore was not
necessarily contemplated for use in the
context of singly-listed SPX options that
only trade on CBOE. Further, as noted
above, a benchmark trade is defined as
an order for which the price is not
based, directly or indirectly, on the
quoted price of the option at the time of
the order’s execution and for which the
material terms were not reasonably
determinable at the time a commitment
to trade the order was made. As also
noted above, however, the price of each
leg of a Variance Trade actually would
take into account the market price of
each series as part of the proposed
39 CBOE
Letter, supra note 4, at 5.
id. at 3. See also supra note 34.
41 See CBOE Letter, supra note 4, at 5.
42 See email from Angelo Evangelo, CBOE, to
Richard Holley, Assistant Director, Commission,
dated January 26, 2012.
40 See
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methodology in which the quoted price
for a series is adjusted upwards or
downwards as necessary.43 CBOE
should monitor for the future use of the
benchmark indicator in the options
markets, and if CBOE or any other
options market begins to use the
benchmark indicator pursuant to the
Linkage Plan, then CBOE should
consider the impact of the potential for
investor confusion, and whether to seek
approval for use of a different indicator
for Variance Trades to avoid investor
confusion.
IV. Conclusion
It is therefore ordered, pursuant to
Section 19(b)(2) of the Act,44 that the
proposed rule change (SR–CBOE–2011–
007) be, and hereby is, approved.
For the Commission, by the Division of
Trading and Markets, pursuant to delegated
authority.45
Kevin M. O’Neill,
Deputy Secretary.
[FR Doc. 2012–2237 Filed 2–1–12; 8:45 am]
BILLING CODE 8011–01–P
SECURITIES AND EXCHANGE
COMMISSION
[Release No. 34–66245; File No. SR–BX–
2012–006]
Self-Regulatory Organizations;
NASDAQ OMX BX, Inc.; Notice of Filing
and Immediate Effectiveness of
Proposed Rule Change Relating To
Amend the Definition of Theoretical
Price
srobinson on DSK4SPTVN1PROD with NOTICES
January 26, 2012.
Pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934
(‘‘Act’’),1 and Rule 19b–4 thereunder,2
notice is hereby given that on January
20, 2012, NASDAQ OMX BX, Inc. (the
‘‘Exchange’’) filed with the Securities
and Exchange Commission
(‘‘Commission’’) the proposed rule
change as described in Items I and II
below, which Items have been prepared
by the self-regulatory organization. The
Exchange filed the proposed rule change
pursuant to Section 19(b)(3)(A) of the
Act,3 and Rule 19b–4(f)(6) thereunder,4
which renders the proposal effective
upon filing with the Commission. The
Commission is publishing this notice to
43 See
solicit comments on the proposed rule
from interested persons.
I. Self-Regulatory Organization’s
Statement of the Terms of Substance of
the Proposed Rule Change
The Exchange proposes to amend
Chapter V, Section 20 (Obvious and
Catastrophic Errors) of the Rules of the
Boston Options Exchange Group, LLC
(‘‘BOX’’) to amend the definition of
theoretical price. The text of the
proposed rule change is available from
the principal office of the Exchange, at
the Commission’s Public Reference
Room and also on the Exchange’s
Internet Web site at https://
nasdaqomxbx.cchwallstreet.com/
NASDAQOMXBX/Filings/.
II. Self-Regulatory Organization’s
Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule
Change
In its filing with the Commission, the
self-regulatory organization included
statements concerning the purpose of,
and basis for, the proposed rule change
and discussed any comments it received
on the proposed rule change. The text
of these statements may be examined at
the places specified in Item IV below.
The self-regulatory organization has
prepared summaries, set forth in
Sections A, B, and C below, of the most
significant aspects of such statements.
A. Self-Regulatory Organization’s
Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule
Change
1. Purpose
The Exchange is proposing a change
to Chapter V, Section 20 (Obvious and
Catastrophic Errors). An obvious error
occurs when the execution price of a
transaction is above or below the
Theoretical Price for the series by a
specified amount. The Exchange
recently submitted an immediately
effective rule change to amend the
definition of Theoretical Price.5 Under
the recently effective rule, the
‘‘Theoretical Price’’ of an option series
is defined, if the series is traded on at
least one other options exchange, as the
mid-point of the National Best Bid or
Offer (‘‘NBBO’’), just prior to the trade
in question. If there are no quotes for
comparison, the Theoretical Price is
determined by the Market Regulation
Center (‘‘MRC’’).6
supra note 34.
5 See Securities Exchange Act Release No. 66093
(January 4, 2012), 77 FR 1543 (January 10, 2012)
(SR–BX–2011–086) Notice of Filing and Immediate
Effectiveness of a Proposal To Amend the
Definition of Theoretical Price (‘‘BX–2011–086’’).
6 MRC is defined in the BOX Rules to mean the
Exchange’s facilities for surveilling and regulating
44 15
U.S.C. 78s(b)(2).
45 17 CFR 200.30–3(a)(12).
1 15 U.S.C. 78s(b)(1).
2 17 CFR 240.19b–4.
3 15 U.S.C. 78s(b)(3)(A).
4 17 CFR 240.19b–4(f)(6).
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The rule change proposed in BX–
2011–086 was immediately effective
upon filing, but not operative for 30
days. As such, it is not yet operative.
The goal of the rule change in BX–2011–
086 was to improve the BOX process for
addressing potentially erroneous trades
to the benefit of all BOX market
participants. While proposing the rule
change, BOX discussed BX–2011–086
with several BOX Options Participants,
and has continued these discussions
following the effective date of the
proposal. Based on these discussions
with its Participants, BOX, after
considering the potential impact of the
change on BOX market participants and
the liquidity on BOX, believes there is
sufficient reason to reverse the rule
change proposed in BX–2011–086. In
addition, BOX will continue analyzing
potential refinements to the BOX
process for addressing potentially
erroneous trades.
As such, the Exchange is proposing to
amend the definition of Theoretical
Price so that when the series is traded
on at least one other options exchange,
the Theoretical Price will be the
‘‘National Best Bid with respect to an
erroneous sell transaction, and National
Best Offer with respect to an erroneous
buy transaction, just prior to the trade
in question.’’ Alternatively, if there are
no quotes for comparison, the
Theoretical Price will continue to be
determined by the MRC. This proposed
rule change would reverse the effective
rule change identified in note 1 [sic] and
amend this provision of the BOX Rules
so that the Theoretical Price continues
to be the National Best Bid or Offer.
2. Statutory Basis
This proposed rule change is designed
to provide the personnel of the MRC
(i.e., BOXR) with a clearly defined
measure of the price on which to base
a determination as to whether or not a
particular transaction was the result of
an obvious error and continue utilizing
the rule that BOX has had in place prior
to the operative date of BX–2011–086.
The Exchange believes the proposed
rule change is consistent with the
Securities Exchange Act of 1934 (the
‘‘Act’’) and the rules and regulations
thereunder and, in particular, the
requirements of Section 6(b) of the Act.7
Specifically, the Exchange believes
the proposed rule change is consistent
with the Section 6(b)(5) 8 requirements
that the rules of an exchange be
the conduct of business for options on BOX. MRC
personnel are employees of BOXR and are not
affiliated with BOX Options Participants.
7 15 U.S.C. 78f(b).
8 15 U.S.C. 78f(b)(5).
E:\FR\FM\02FEN1.SGM
02FEN1
Agencies
[Federal Register Volume 77, Number 22 (Thursday, February 2, 2012)]
[Notices]
[Pages 5286-5289]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-2237]
[[Page 5286]]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-66265; File No. SR-CBOE-2011-007]
Self-Regulatory Organizations; Chicago Board Options Exchange,
Incorporated; Order Approving a Proposed Rule Change To Adopt Rules
Governing S&P 500 Option Variance Basket Trades
January 27, 2012.
I. Introduction
On October 26, 2011, Chicago Board Options Exchange, Incorporated
(``Exchange'' or ``CBOE'') filed with the Securities and Exchange
Commission (``Commission''), pursuant to Section 19(b)(1) of the
Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to adopt rules in connection with
a mechanism to quote for, and trade, at a single aggregate price, a
basket of S&P 500 Index Options comprising a pre-specified series of
listed calls and puts that are constructed to assist market
participants who use such baskets of options as part of a trading
strategy to obtain or hedge variance exposure on the S&P 500 Index. The
proposed rule change was published for comment in the Federal Register
on November 16, 2011.\3\ The Commission received one comment letter on
the proposed rule change.\4\ This order approves the proposed rule
change.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Securities Exchange Act Release No. 65725 (November 10,
2011), 76 FR 71092 (``Notice'').
\4\ See Letter dated December 14, 2011, from Angelo Evangelou,
Assistant General Counsel, Legal Division, CBOE, to Elizabeth M.
Murphy, Secretary, Commission (``CBOE Letter'').
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II. Description of the Proposed Rule Change
The Exchange is proposing a new offering, called S&P 500 Variance
Trades (``Variance Trades''), which will allow market participants to
trade a basket of pre-specified series of S&P 500 Index options (``SPX
options'') in a single transaction. Each pre-specified basket of series
of options offered by the Exchange will be constructed using a
methodology designed to produce options baskets that can be used by
market participants as part of a trading strategy to obtain or hedge
variance exposure on the S&P 500 Index.\5\ Currently, a trader would
need to separately purchase or sell each of the options in a pre-
specified Variance Trade basket to acquire this type of options
exposure. In its filing, the Exchange notes that demand for volatility
products has increased in recent years, and believes that the proposed
Variance Trades would provide investors with an additional way to
efficiently trade S&P 500 volatility.\6\
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\5\ The Exchange notes that Variance Trades do not replicate
variance swaps. See Notice, supra note 3, 76 FR 71092, n.4. The
Commission understands that Variance Trades could be useful to
market participants who employ trading strategies to hedge or
replicate variance swaps on the S&P 500 Index. A variance swap is a
derivative in which two counterparties agree to exchange future cash
flows based on the realized level of volatility of a tradable
financial instrument over a pre-specified, future period of time.
\6\ See Notice, supra note 3, 76 FR 71092, text accompanying
n.4. See also CBOE Letter, supra note 4, at 3.
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A Variance Trade consists of a basket of SPX options across
different series, where the constituent options of the basket are put
and call options with the same expiration date that are centered around
an at-the-money strike price.\7\ The Exchange will make one or more
Variance Trade baskets available for trading each day. Each basket will
consist of a portfolio of SPX options defined by the Exchange the day
before it is available for trading. Each basket will have a unique
ticker symbol.
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\7\ Detailed examples of how Variance Trades would be
constructed and executed on the Exchange are provided in the Notice.
See Notice, supra note 3.
---------------------------------------------------------------------------
Unlike a typical multi-legged option transaction whose price is
expressed as a net dollar price, the price of a Variance Trade will be
quoted in ``volatility terms'' (i.e., a single number that reflects an
aggregate implied volatility for the entire options basket). Trade
quantities will be expressed in contracts, and each contract will have
a multiplier of $10,000 or more, as determined and announced by the
Exchange in advance.\8\ The Exchange expects typically to specify a
higher multiplier than $10,000, but has proposed to establish a $10,000
minimum to allow greater flexibility for short-dated options and low
volatility levels.\9\
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\8\ The multiplier for Variance Trades represents the aggregate
``vega'' exposure of the SPX option series that comprise the
Variance Trade portfolio. Vega describes the change in value of a
contract corresponding to a one-point change in volatility.
\9\ See Notice, supra note 3, at n.6.
---------------------------------------------------------------------------
A participant will submit a Variance Trade order with a limit price
expressed in terms of volatility (market orders would not be permitted)
and a contract size.\10\ Market makers also will be allowed to provide
quotes for Variance Trade baskets. Orders and quotes will be ranked
pursuant to one of the matching algorithms set forth in CBOE Rule
6.45A, which may be different from the matching algorithm in place for
other option products, including SPX. Once a Variance Trade match
occurs, the Exchange will use a formula to deconstruct the trade into
individual trades in the constituent SPX options that compose the
basket, and those individual trades each will be sent to OPRA as
separate trades.\11\
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\10\ Variance Trades will trade only electronically.
\11\ See Notice, supra note 3, 76 FR 71093 (setting forth the
formula).
---------------------------------------------------------------------------
The algorithm that deconstructs a Variance Trade into its
constituent SPX option legs uses a two step process. First, based on
the matched implied volatility (i.e., the price of the trade), the
system will calculate the exact number of contracts for each SPX option
series composing the Variance Trade.\12\ Second, the system will
calculate resulting trade prices for each SPX option series through an
iterative process in which current implied volatilities for each option
series are collectively adjusted upwards or downwards until the
aggregate implied volatility of the overall basket equals the matched
implied volatility as quoted. The individual price of any given option
series in the basket generally would not be the same as (or directly
related to) the prevailing market price for that series because the
entire basket will be priced in the aggregate in order to reflect the
desired volatility level.
---------------------------------------------------------------------------
\12\ Unlike a typical complex order, the terms of a Variance
Trade order would not pre-specify the number of contracts for each
individual series composing the trade. These quantities instead
depend on the implied volatility of the options basket itself, which
is not known until a matched implied volatility for a trade has been
determined.
---------------------------------------------------------------------------
The Exchange's proposal will allow the constituent SPX option
trades of a Variance Trade to be executed and reported without regard
to existing bids and offers on the Exchange in the individual SPX
options series at the time of the transaction.\13\ Once prices are
determined for a trade in each constituent series, the system will
execute and report the constituent trades to OPRA.\14\ In addition, the
executions in the individual constituent series will be sent to the
Options
[[Page 5287]]
Clearing Corporation (``OCC'') for clearing.
---------------------------------------------------------------------------
\13\ See Notice, supra note 3, 76 FR 71093.
\14\ To highlight that executions of Variance Trades are not
associated with the quoted prices in the respective SPX series at
the time of execution, each constituent SPX option execution will be
reported to OPRA with the ``benchmark'' indicator. The benchmark
indicator was created to facilitate the execution of benchmark
orders as contemplated by the Options Order Protection and Locked/
Crossed Market Plan (the ``Linkage Plan''). A benchmark order is an
order for which the price is not based, directly or indirectly, on
the quoted price of the option at the time of the order's execution
and for which the material terms were not reasonably determinable at
the time a commitment to trade the order was made.
---------------------------------------------------------------------------
As there are no position limits for SPX options, the Exchange did
not propose any position limits for executions associated with Variance
Trades. Reporting limits applicable to SPX options will apply pursuant
to CBOE Rule 24.4, Interpretation and Policy .03.
The Exchange expects Variance Trades to appeal to institutional
users and not to retail customers.\15\ Because of the complex nature of
Variance Trades, the Exchange will only allow orders in Variance Trades
to be submitted by members who have affirmatively communicated to the
Exchange a desire to submit orders in Variance Trades. Thus, retail
brokerage firms (or any other firms) that have not specifically opted
to submit orders in Variance Trades will not be allowed to send such
orders to CBOE (any such orders from such firms will be rejected).
---------------------------------------------------------------------------
\15\ See id. at 71101.
---------------------------------------------------------------------------
The Exchange represents that appropriate surveillance will be in
place in connection with Variance Trades.\16\ Further, the Exchange
states that it has analyzed its capacity and represents that it and the
Options Price Reporting Authority have the necessary systems capacity
to handle the additional traffic that it expects will be associated
with Variance Trades.\17\
---------------------------------------------------------------------------
\16\ See id.
\17\ See id.
---------------------------------------------------------------------------
III. Discussion and Commission's Findings
After careful review, the Commission finds that the proposed rule
change is consistent with the requirements of Section 6 of the Act \18\
and the rules and regulations thereunder applicable to a national
securities exchange.\19\ In particular, the Commission finds that the
proposed rule change is consistent with Section 6(b)(5) of the Act,\20\
which requires, among other things, that the Exchange's rules be
designed to prevent fraudulent and manipulative acts and practices, to
promote just and equitable principles of trade, to foster cooperation
and coordination with persons engaged in facilitating transactions in
securities, to remove impediments to and perfect the mechanism of a
free and open market and a national market system, and, in general, to
protect investors and the public interest.
---------------------------------------------------------------------------
\18\ 15 U.S.C. 78f.
\19\ In approving this proposed rule change, the Commission has
considered the proposed rule's impact on efficiency, competition,
and capital formation. See 15 U.S.C. 78c(f).
\20\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------
The introduction of Variance Trades is designed to allow
professional market participants to more efficiently trade an entire
option portfolio to obtain or hedge variance exposure on the S&P 500
Index. Such traders otherwise would need to purchase or sell each
option individually to acquire exposure to such a basket of options in
a complex web of simultaneously-executed transactions that is very
difficult to reproduce as a series of individual trades. To the extent
that traders currently seek out similar products offered on the over-
the-counter securities markets, the proposed rule change will permit
them to trade Variance Trades on a registered national securities
exchange. The Commission believes that the proposal will benefit
participants by providing an alternative to the over-the-counter market
through the functionality to trade these baskets of exchange-listed
options in a national securities exchange environment that offers the
potential of enhanced liquidity, transparency, and oversight, and where
counterparty risk can be mitigated through the role of OCC. Moreover,
the requirement that permit holders affirmatively indicate to the
Exchange a desire to transact in Variance Trades before the Exchange
accepts and processes orders from such firms will serve as an
additional safeguard to protect against the inadvertent submission of
Variance Trade orders.
In the Notice, the Commission sought comment on two particular
issues relating to the proposed Variance Trades: (1) Allowing the
constituent SPX option trades of a Variance Trade to be executed and
reported without regard to existing bids and offers on the Exchange in
SPX at the time of the transaction; and (2) use of the benchmark
indicator when reporting the constituent legs of a Variance Trade.\21\
CBOE submitted a letter in response to the Commission's request for
comments, urging the Commission to approve its proposal.\22\ The
Commission did not receive any other comments.
---------------------------------------------------------------------------
\21\ See Notice, supra note 3, 76 FR 71102.
\22\ See CBOE Letter, supra note 4.
---------------------------------------------------------------------------
On the first point, the Commission requested commenters' opinions
on whether allowing the constituent SPX option legs of a Variance Trade
to be executed and reported without regard for existing bids and offers
on the Exchange in SPX at the time of the transaction would be
consistent with the Exchange Act and what, if any, potential impact
this proposal might have on market participants.\23\ As noted above,
the Commission received no comments except from CBOE.
---------------------------------------------------------------------------
\23\ See Notice, supra note 3, 76 FR 71102.
---------------------------------------------------------------------------
While multi-leg complex orders can trade on CBOE at the same price
as existing booked interest on CBOE for one or more legs only if they
improve the price on another leg,\24\ Variance Trades will have no
similar restrictions, and the constituent legs could thus trade without
regard to quotes and orders with priority on CBOE's book.\25\
Exceptions from intra-market priority can raise concerns relating to
the protection of resting quotes and orders on an exchange's book and
the potential impact on the price discovery process.\26\
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\24\ See CBOE Rule 6.45(B)(b)(ii).
\25\ Because SPX options are singly-listed on CBOE, and because
the only components of a Variance Trade will be SPX options, CBOE's
proposal does not implicate inter-market order protection concerns.
\26\ See e.g.,Securities Exchange Act Release No. 63955
(February 24, 2011), 76 FR 11533, at 11540 (March 2, 2011) (SR-ISE-
2010-73).
---------------------------------------------------------------------------
In its letter, the Exchange argues that orders and quotes in
individual SPX options series would not be disadvantaged when the
various legs of a deconstructed Variance Trade execute, because traders
in the individual SPX option series are not bidding for or offering the
entire Variance Trade, which is the relevant order being executed.\27\
While true, that argument is inconsistent with the treatment of other
complex orders, noted above, which are required to interact with
resting orders with priority except under limited circumstances.
---------------------------------------------------------------------------
\27\ See CBOE Letter, supra note 4, at 2.
---------------------------------------------------------------------------
In addition, CBOE believes that requiring the deconstructed
components of a Variance Trade to interact with orders resting on the
CBOE's SPX book would impede and frustrate traders' desire to enter
into Variance Trades and achieve their investment objectives.\28\
Rather, CBOE argues that introducing an exchange-traded functionality
that allows investors to place a single order expressed in volatility
terms and that permits those investors to establish a specific
volatility profile is consistent with Section 6(b)(5) of the Act in
that it removes impediments to, and perfects the mechanism for, a free
and open market.\29\ The Exchange asserts that if some constituent
trades were required to be executed separately from the Variance Trade
it would materially alter the pricing of the Variance Trade as well as
its variance exposure, and would require the investor to execute
separate trades in one or more constituent SPX options in an attempt to
achieve the
[[Page 5288]]
objective variance exposure.\30\ The Exchange also states that
requiring that positions in the individual constituent series be
assigned different prices than those assigned by the algorithm would
mean that either the Variance Trade execution price must be modified or
a different and less efficient algorithm would be required to assign
prices to certain constituent SPX options to reach the trade's stated
execution price.\31\ The Exchange believes both alternatives would
destroy the appeal of the Variance Trade process.\32\ According to the
Exchange, its proposal is narrowly crafted to prevent abuse and would
facilitate beneficial volatility trading and hedging activity that
would serve the needs of the marketplace.\33\
---------------------------------------------------------------------------
\28\ See id. at 3.
\29\ See id.
\30\ See id. at 4.
\31\ See id.
\32\ See id.
\33\ See id.
---------------------------------------------------------------------------
Further, CBOE argues that the prices of the constituent option
series are unrelated to quotes and orders on CBOE's book and that
requiring the constituent legs of a Variance Trade to interact with the
book could introduce inefficiencies in the pricing of Variance
Trades.\34\ The Commission notes that the fact that a given trade in a
constituent option series may trade through the price of resting
interest is a consequence of the Variance Trade methodology and the
fact that a Variance Trade is priced not in net dollar terms but in
volatility terms. Unlike complex orders (as defined in CBOE's
rules),\35\ the terms of a Variance Trade order would not pre-specify a
quantity for each individual series. Rather, since the exact size
(number of contracts) in each constituent series is a function of the
matched implied volatility, it can only be computed once a match has
occurred. In addition, the trade prices of the individual legs are
derived simultaneously using a complex iterative process that is
conducted after a match has occurred.
---------------------------------------------------------------------------
\34\ See id. The Commission notes that despite CBOE's assertion
that the prices of the constituent option series of a Variance Trade
would be unrelated to quotes and orders on CBOE's book, the proposed
methodology CBOE would use for determining option prices in
connection with Variance Trades starts with the actual quoted option
prices themselves and then adjusts them upwards or downwards as
needed. Thus, the price of each option leg of a Variance Trade
actually would take into account the market price of each series.
\35\ See CBOE Rule 6.53C.
---------------------------------------------------------------------------
Requiring the component legs of a Variance Trade basket to interact
with resting orders in CBOE's SPX book would materially alter the
computed prices for each component leg and therein would frustrate the
ability of participants to consummate such transactions and undermine
the objective of the trade. Specifically, the Variance Trade algorithm
calculates a series of contract sizes and prices that span a
considerable number of series and the interaction of these trades with
resting orders would impact that process to an extent that could make
it difficult, if not impossible, to consummate a Variance Trade
transaction. Accordingly, in light of the unique structure and
calculation methodology of the Variance Trade, as discussed more fully
above, the Commission believes that allowing Variance Trades to execute
without interacting with pre-existing interest on CBOE is appropriate
and consistent with the Act.
The second point on which the Commission requested comment in the
Notice relates to the use of the benchmark trade reporting indicator
when reporting the constituent legs of a Variance Trade. The Exchange's
proposal seeks to use the ``benchmark'' indicator for informational
purposes when reporting executions of the constituent legs of a
Variance Trade transaction, even though such trades would not be
``benchmark'' trades pursuant to Section 5(b)(xi) of the Linkage Plan,
which by its terms applies only to inter-market (not intra-market)
order protection.\36\ The Commission received no comments except from
CBOE.
---------------------------------------------------------------------------
\36\ A benchmark order is an order for which the price is not
based, directly or indirectly, on the quoted price of the option at
the time of the order's execution and for which the material terms
were not reasonably determinable at the time a commitment to trade
the order was made. See CBOE Rule 6.81(b)(10) and Section 5(b)(xi)
of the Linkage Plan.
---------------------------------------------------------------------------
The Exchange believes that the benchmark indicator, while it was
created for the reporting of multiply-listed option executions,
nevertheless would be useful to append to the execution of constituent
series of a Variance Trade so SPX traders know that the executions were
not related to the quoted price at the time of the print.\37\ In its
letter, the Exchange argues that the rationale behind the benchmark
indicator also applies to Variance Trades.\38\ Specifically, the
Exchange believes that the constituent SPX options executions clearly
fall within the definition of a benchmark trade in that they are not
related to the quoted SPX prices at the time of execution, which is how
the benchmark indicator would be used in the context of multiply-listed
options.\39\ Further, CBOE believes that the fact that SPX options only
trade on CBOE should not alter the conclusion that benchmark trades be
exempt from certain priority considerations because they utilize
transparent pricing methods that do not take into account the quoted
market in the applicable security.\40\ The Exchange believes that the
proposed use of the benchmark trade indicator would appropriately alert
SPX market participants that the prices of the executed SPX constituent
trades were not related to the quoted SPX prices at the time of the
execution, in a way that would avoid any market confusion. The Exchange
also believes that it would facilitate its surveillance of the
constituent trades.\41\
---------------------------------------------------------------------------
\37\ Currently, CBOE does not offer functionality or order types
that utilize the benchmark exception to the Linkage Plan. See
Notice, supra note 3, 76 FR 71093, n.7.
\38\ CBOE Letter, supra note 4, at 3.
\39\ CBOE Letter, supra note 4, at 5.
\40\ See id. at 3. See also supra note 34.
\41\ See CBOE Letter, supra note 4, at 5.
---------------------------------------------------------------------------
The Commission believes that the use of an indicator for the trades
in the constituent series of a Variance Trade is appropriate to alert
market participants that the executions are not regular market
transactions in order to guard against investor confusion in seeing
individual options trade at prices that may be above or below
prevailing market prices.
CBOE has informed the Commission that, at the present time, the
benchmark indicator is not used in the options markets.\42\ In reliance
on this representation, the Commission believes the potential for
investor confusion by marking the constituent trades as benchmark
trades would be minimal, and that the use of the benchmark indicator
for these purposes is reasonable at this time. The Commission notes,
however, that use of another indicator may be preferable given that the
benchmark indicator was intended for use in the context of inter-market
order protection and therefore was not necessarily contemplated for use
in the context of singly-listed SPX options that only trade on CBOE.
Further, as noted above, a benchmark trade is defined as an order for
which the price is not based, directly or indirectly, on the quoted
price of the option at the time of the order's execution and for which
the material terms were not reasonably determinable at the time a
commitment to trade the order was made. As also noted above, however,
the price of each leg of a Variance Trade actually would take into
account the market price of each series as part of the proposed
[[Page 5289]]
methodology in which the quoted price for a series is adjusted upwards
or downwards as necessary.\43\ CBOE should monitor for the future use
of the benchmark indicator in the options markets, and if CBOE or any
other options market begins to use the benchmark indicator pursuant to
the Linkage Plan, then CBOE should consider the impact of the potential
for investor confusion, and whether to seek approval for use of a
different indicator for Variance Trades to avoid investor confusion.
---------------------------------------------------------------------------
\42\ See email from Angelo Evangelo, CBOE, to Richard Holley,
Assistant Director, Commission, dated January 26, 2012.
\43\ See supra note 34.
---------------------------------------------------------------------------
IV. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\44\ that the proposed rule change (SR-CBOE-2011-007) be, and
hereby is, approved.
\44\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\45\
---------------------------------------------------------------------------
\45\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2012-2237 Filed 2-1-12; 8:45 am]
BILLING CODE 8011-01-P