Proposed Contract Adjustment Changes To Eliminate Rounding - Revised

DATE: JANUARY 9, 2006
SUBJECT: PROPOSED CONTRACT ADJUSTMENT CHANGES TO ELIMINATE ROUNDING - REVISED

The OCC Board of Directors recently approved a change in the way contract adjustments are
executed for a wide variety of stock splits and distributions. The proposed change
represents a significant departure from long-standing practice. The change will be
effective on a date to be announced following SEC approval and distribution of a supplement
to the Options Disclosure Document (see “Effective Date” below).

Background and Rationale

Currently, Article VI, Section 11 of OCC’s By-Laws specifies two alternative methods of
adjusting for stock splits and stock dividends. In cases where one or more whole shares are
issued with respect to each outstanding share, the number of outstanding option contracts is
correspondingly increased and strike prices are proportionately reduced to reflect the split
ratio. For example, in the event of a 3-for-1 split, an XYZ 60 option calling for the delivery of
100 shares of XYZ stock would be divided into three XYZ 20 options, each calling for the
delivery of 100 shares of XYZ stock.

In all other cases, the deliverable and premium/strike multiplier are increased, and strike prices
are reduced. For example, in a 3-for-2 split, an XYZ 40 option calling for the delivery of 100
shares would be adjusted to a new adjusted option symbol that would call for the delivery of
150 shares with a reduced strike price of 26 5/8 (40 / 1.5 = 26.6666, rounded to the nearest
eighth). The new adjusted option symbol would also have a premium/strike multiplier of 150.

Since equity option strike prices are currently denominated in eighths, adjusting strikes
according to either of the methods mentioned above will periodically require rounding of
adjusted strikes to the nearest eighth. The need to round to the nearest eighth results in
economic inequities measured in terms of the in-the-money value of positions after the
adjustment. These inequities due to rounding have historically been accepted as immaterial.
Recently, however, they have become a source of concern to exchanges and market
participants. Over the years, option trading volume and open interest have increased
significantly. Larger positions, sophisticated trading techniques, and spread strategies can
easily magnify small single-contract rounding inequities into sizeable amounts. The OCC
Board of Directors has determined it desirable to implement an adjustment method that will
eliminate rounding inequities that arise solely as an artifact of the adjustment process.

New Method

The need for rounding strike prices can be avoided by using a different adjustment
methodology - adjusting the deliverable but not the strike price or premium/strike
multiplier (the “New Method”). Going back to the example of the 3-for-2 stock split, it would
be possible to adjust outstanding XYZ options to call for the delivery of 150 shares of XYZ
stock, leave the strike price at 40, and continue to use 100 as the “multiplier” for calculating
premiums and extended strike prices. This would eliminate the need for rounding because the
strike price would remain unchanged (see examples below). This is the method currently used
for property distributions such as spin-offs, mergers, or stock dividends with cash in lieu of
fractional shares. This method can simply be extended to cover a wider variety of contract
adjustments.

The basic features of all adjustments under the New Method are:
a) Strike prices remain unchanged.
b) The additional shares are added to the contract deliverable.
c) The adjusted option continues to use 100 as the multiplier to extend premium
and strike amounts.
d) The number of contracts remains the same.

The change approved by the OCC Board of Directors was described in an OCC Information
Memo earlier this year (Memo #20872). In response to comments from Clearing Members and
option exchanges, the OCC Board modified its original approach to provide operational
efficiencies. The modified and current proposal is as follows: With the exception of 2 for 1
and 4 for 1 stock splits, all contract adjustments in response to splits or stock
distributions shall be done using the “New Method”. Because 2 for 1 and 4 for 1 splits are
not likely ever to require rounding of strikes to eighths, these events would be handled using
current methods. (In the case of 2 for 1 and 4 for 1 splits, if rounding of strike prices would
otherwise occur in a contract adjustment using current methods, then the “New Method” of
contract adjustment shall be used for these splits as well. The New Method would be used if
any strike price would otherwise require rounding, and would be applied to all strikes of the
option to be adjusted.)

OCC notes that inequities due to rounding would not present a problem if option strike prices
could be denominated in decimals (pennies). OCC’s systems can presently accommodate
decimal strike prices, but OCC is aware that many industry participants cannot. OCC’s Board
intends that the new adjustment method to avoid rounding will be an interim solution – until
such time as the option industry can accommodate decimal strike prices for equity options.
Accordingly, the New Method will apply only to equity options denominated in fractions.

Effective Date

This change in adjustment methodology requires a change in the OCC By-Laws which must be
approved by the Securities and Exchange Commission. Also, a supplement to the Options
Disclosure Document describing the change will need to be distributed. The New Method of
option adjustment will not be implemented until these events have occurred. OCC estimates a
minimum of 4-5 months will be needed. OCC will provide advance notice of the effective date
for the New Method as soon as practicable. OCC understands the option exchanges will also
be publishing notices and providing educational efforts to prepare for this change.

Important Option Trading Considerations

It will be important for option investors to realize that after adjustments are made using the
New Method, it will no longer be possible to determine if an adjusted option is in- or
out-of-the-money by simply comparing the underlying stock price to the option strike
price. For example, returning to the example of the 3 for 2 split (see above), if an investor
simply compared the adjusted strike to the underlying stock price – as an investor does under
current adjustment methodology - the investor might erroneously assume that with a stock
price of 28, an adjusted XXX 40 Call option is 12 points out-of-the-money (40 – 28 = 12).
Actually, that option series is 2 points in-the-money: deliverable value of $28 x 150 = $4200,
versus the strike value of $40 x 100 = $4000. In this case, an option trader wishing to bid the
in-the-money amount would bid “2” or $200 ($2 x 100, the premium multiplier). After the New
Method is effective, option investors must always be aware of the number of shares in
the deliverable and the multiplier used for premium and strike dollar extensions.

Although this trading consideration resulting from the New Method is an important change for
the split adjustments, it is already familiar to the options industry, as this methodology for
adjustments has long been used for spinoffs and mergers. In these kinds of adjustments -
which often involve multiple stock components in the deliverable, unusual share amounts
and/or cash components – it is also not possible to determine in- or out-of-the-money value by
simply comparing a single stock price to the strike price. (Also in these cases, the
premium/strike multiplier remains 100.)

 

You mention very important concerns. Seemingly, there will be many uninformed who will be making mistakes. People who trade options must patiently review these changes and understand them well.