The Board of Governors has
been asked to determine whether the business of selling instruments
described as “deep-in-the-money put and call options” would involve
an extension of credit for the purposes of the Board’s regulations
governing margin requirements for securities transactions. Most of
such options would be of the “call” type, such as the following proposal
that was presented to the Board for its consideration:
An ordinary “put” is an option given to a person to sell
to the writer of the put a specified amount of securities at a stated
price within a certain time. A “call” is an option given to a person
to buy from the writer a specified amount of securities at a stated
price within a certain time. To be freely saleable, options must be
indorsed, or guaranteed, by a member firm of the exchange on which
the security is registered. The guarantor charges a fee for this service.
The option embodied in the normal put or call is exercisable
either at the market price of the security at the time the option
is written, or some “points away” from the market. The price of a
normal option is modest by comparison with the margin required to
take a position. Writers of normal options are persons who are satisfied
with the current price of a security, and are prepared to purchase
or sell at that price, with the small profit provided by the fee.
Moreover, since a large proportion of all options are never exercised,
a person who customarily writes normal options can anticipate that
the fee would be clear profit in many cases, and he will not be obliged
to buy or sell the stock in question.
The stock exchanges require that the writer of an option
deposit and maintain in his margin account with the indorser 30 percent
of the current market price in the case of a call (unless he has a
long position in the stock) and 25 percent in the case of a put (unless
he has a short
position in the stock). Many indorsing firms in fact require larger
deposits. Under section 220.3(a) of Regulation T, all financial relations
between a broker and his customer must be included in the customer’s
general [now margin] account, unless specifically eligible for one
of the special accounts authorized by section 220.4. Accordingly,
the writer, as a customer of the member firm, must make a deposit,
which is included in his general account.
In order to prevent the deposit from being available against
other margin purchases, and in effect counted twice, section 220.3(d)(5)
requires that in computing the customer’s adjusted debit balance,
there shall be included “the amount of any margin customarily required
by the creditor in connection with his indorsement or guarantee of
any put, call, or other option”. No other margin deposit is required
in connection with a normal put or call option under Regulation T.
Turning to the “deep in the money” proposed option contract
described above, the price paid by the buyer can be divided into (1)
a deposit of 30 percent of the current market value of the stock,
and (2) an additional fixed charge, or fee. To the extent that the
price of the stock rose during the 30 ensuing days the proposed instrument
would produce results similar to those in the case of an ordinary
profitable call, and the contract right would be exercised. But even
if the price fell, unlike the situation with a normal option, the
buyer would still be virtually certain to exercise his right to purchase
before it expired, in order to minimize his loss. The result would
be that the buyer would not have a genuine choice whether or not to
buy. Rather, the instrument would have made it possible for him, in
effect, to purchase stock as of the time the contract was written
by depositing 30 percent of the stock’s current market price.
It was suggested that the proposed
contract is not unusual, since there are examples of ordinary options
selling at up to 28 percent of current market value. However, such
examples are of options running for 12 months, and reflect expectations
of changes in the price of the stock over that period. The 30-day
contracts discussed above are not comparable to such 12-month options,
because instances of true expectations of price changes of
this magnitude over a 30-day period would be exceedingly rare. And
a contract that does not reflect such true expectations of price change,
plus a reasonable fee for the services of the writer, is not an option
in the accepted meaning of the term.
Because of the virtual certainty that the contract right
would be exercised under the proposal described above, the writer
would buy the stock in a margin account with an indorsing firm immediately
on writing the contract. The indorsing firm would extend credit in
the amount of 20 percent of the current market price of the stock,
the maximum permitted by the current section 220.8 (supplement to
Regulation T). The writer would deposit the 30 percent supplied by
the buyer, and furnish the remaining 50 percent out of his own working
capital. His account with the indorsing firm would thus be appropriately
margined.
As to the buyer, however, the writer would function as
a broker. In effect, he would purchase the stock for the account,
or use, of the buyer, on what might be described as a deferred payment
arrangement. Like an ordinary broker, the writer of the contract described
above would put up funds to pay for the difference between the price
of securities the customer wished to purchase and the customer’s own
contribution. His only risk would be that the price of the securities
would decline in excess of the customer’s contribution. True, he would
be locked in, and could not liquidate the customer’s collateral for
30 days even if the market price should fall in excess of 30 percent,
but the risk of such a decline is extremely slight.
Like any other broker who extends credit in
a margin account, the writer who was in the business of writing and
selling such a contract would be satisfied with a fixed predetermined
amount of return on his venture, since he would realize only the fee
charged. Unlike a writer of ordinary puts and calls, he would not
receive a substantial part of his income from fees on unexercised
contract rights. The similarity of his activities to those of a broker, and the dissimilarity
to a writer of ordinary options, would be underscored by the fact
that his fee would be a fixed predetermined amount of return similar
to an interest charge, rather than a fee arrived at individually for
each transaction according to the volatility of the stock and other
individual considerations.
The buyer’s general account with the writer would in effect
reflect a debit for the purchase price of the stock and, on the credit
side, a deposit of cash in the amount of 30 percent of that price,
plus an extension of credit for the remaining 70 percent, rather than
the maximum permissible 20 percent.
For the reason stated above, the Board concluded that
the proposed contracts would involve extensions of credit by the writer
as broker in an amount exceeding that permitted by the current supplement
to Regulation T. Accordingly, the writing of such contracts by a brokerage
firm is presently prohibited by such regulation, and any brokerage
firm that indorses such a contract would be arranging for credit in
an amount greater than the firm itself could extend, a practice that
is prohibited by section 220.7(a). 1970 Fed. Res. Bull. 280;
12 CFR 220.122.
There
have been many developments since this interpretation was issued,
notably a reduction in initial and maintenance margins and the introduction
of exchange-traded options. The Board’s reasoning is still valid for
options not traded on an exchange. Now covered by sections 220.4(a),
220.13, and 220.18 of Regulation T (as revised 1983).
