March 23, 2006
To the Members of the Commission:
I as a professional Market Maker in options on the American Stock Exchange would like to comment on the proposed rule changes discussed in SR-OCC-2006-01.
Specifically I would like to address the special dividend adjustments proposed. Each market participant creates a pricing model with inputs that include the probability of dividend increases, decreases, and special dividends. LEAPS and other options with significant time value are priced using the probability of dividend increases as well as special dividends. Many participants research the likelihood of these dividends and have a different model that generally produces a tighter market. The rule as it stands is clear and we are accustomed to it. The proposed rule change that would create a new WRAP for any contract that delivers more than $12.50 in dividends would be a dramatic change from our existing model.
If it is accepted it should at best be brought in for new classes of options only. Existing options have been priced and traded with an understanding of the existing pricing framework and models. Since adding months that incorporate this new approach mixed with months that do not would create significant confusion for customers I believe incorporating it any earlier than Feb 2008 would create issues.
Another issue that needs to be addressed is the creation of many more wrap symbols for options classes within one stock. While this is the only way to adequately handle the cash-in-lieu delivery embedded within the option it creates added confusion for customers. Explaining to a broker that reports to the customer may be tedious and time consuming in a world that values execution speed and accuracy, but it is impossible to explain this to an electronic customer. This customer in fact may not realize the difference until settlement and may suffer losses due to his error. Even now with less wraps there is confusion (look at the various JBLU wraps and their pricing differences) that often results in losses for the customer, negotiations and broken trades.
Once these wraps are created exchange and market participants (market makers and specialists here) need to model them and maintain two sided continuous markets. While there should be no issue with technology here – the quote traffic and pricing updates may become a burden to the exchanges systems. I am sure this can be addressed, but the exchanges should comment on what this may entail for them.
On the whole I feel the 10% adjustment rule is clear and maintains a system and rule set that we are familiar with and have traded with for some time. If there is a need to make changes to it – they should be made over a timeframe that allows for existing positions to settle. Some care as to the confusion created for customers should be taken and perhaps an associated change in the various exchange obvious error rules and procedures is required as well.