Subject: File No. SR-C2-2011-008
From: Randall Mayne
Affiliation: Blue Capital Group

March 18, 2011

I hope that we have not lost our "institutional memory" regarding why we went to the, now-common, "AM print" expiration for broad-based index options in the first place:

In the mid/late 1980's, the broad underlying market would experience violent swings precisely "on the close" of index futures and options expiration dates...especially on the major Mar/Jun/Sep/Dec expiration Fridays. (Remember triple witching?)
These major moves were caused by massive unidirectional "market on close" orders in large baskets of SP500 and SP100 member stocks by deep-pocketed professional trading entities. These traders could rightly defend their actions by pointing to the "delta neutrality no profit or loss" "convergence" between their expiring derivatives and underlying positions.
The resultant, "final minute" moves were exacerbated by the NYSE specialists who had to fill these orders by taking on large contra-inventories which they would have to hold over a weekend. So they justified the extreme results of the "Closing Print" to where the stable market had been moments before the onslaught. In most cases, these large Friday-close prices were unwound with the first of Monday morning trades and the specialists did just fine.
The collective market of the non-expiring derivatives would be aware of the obviously temporary nature of this dislocation of the spot on the close. Hence the non-expiring index options futures nearly always remained in-line with the pre-dislocation underlying.
This allowed many professionals, to anticipate this dislocation by trading what is commonly referred to as the "roll" between expiring futures (option-synthetic and/or regular) and the non-expiring ones.
The savvy index professional could play this well either by studying open interest information, watching players' actions in pre-expiration dates, or by making friends within the large basket trading entities to obtain a better than average guess for the direction of the closing print".
In those days, the American-style OEX option was king and this game could therefore be played not only Expiration Friday, but also on just about any day - but especially Expiration Thursday and Wednesday. Large dislocations on those days allowed for excellent opportunities to exercise cash-settled index options for large profits.
While these strategies were certainly not without risk, the odds were well in favor of the professional. Was it unfair?...maybe, maybe not. The professional, paid to be on the exchange floor, did his homework and took risks. However, in most cases, the typical public customer had virtually no chance of benefitting from these events, and often, especially those with short OEX option positions, would lose regularly as their options/futures expired - or were exercised - to the dislocated index-closing prices.
The index derivative business, right or wrongly, received LOTS of bad media attention for this phenomenon during that era. Claims of manipulation and "uneconomic exercise of cash-settle options" were rampant from the damaged parties.
This led to the advent of the far more innocuous, and perhaps more fair "AM-Print" method of determining the final value for expiring index options. To judge by the abatement of the negative press, hindsight would seem to support that the AM-Print made for a more level playing field.
Is it safe to return to the dominance of PM-settled index options and futures? Maybe today's era, dominated by electronic execution of stock, futures, and options is less likely to be overwhelmed by such large Market-On-Close executions...or is it? Could it be worse this time around?
This answer does not seem clear, but, in either case, I believe the regulatory powers must carefully, and perhaps painfully revisit the history of the PM-Settled listed index derivative, and the birth of AM-Settlement.