[Code of Federal Regulations]
[Title 12, Volume 3]
[Revised as of January 1, 2003]
From the U.S. Government Printing Office via GPO Access
[CITE: 12CFR220.122]

[Page 27-29]
 
                       TITLE 12--BANKS AND BANKING
 
                   CHAPTER II--FEDERAL RESERVE SYSTEM
 
PART 220--CREDIT BY BROKERS AND DEALERS (REGULATION T)--Table of Contents
 
Sec. 220.122  ``Deep in the money put and call options'' as extensions of credit.

    (a) 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:

    If X stock is selling at $100 per share, the customer would pay 
about $3,250 for a contract to purchase 100 shares of X at $70 per share 
within a 30-day period. The contract would be guaranteed by an exchange 
member, as are standard ``puts'' and ``calls''. When the contract is 
made with the customer, the seller, who will also be the writer of the 
contract, will immediately purchase 100 shares of X at $100 per share 
through the guarantor member firm in a margin account. If the customer 
exercises the option, the shares will be delivered to him; if the option 
is not exercised, the writer will sell the shares in the margin account 
to close out the transaction. As a practical matter, it is anticipated 
that the customer will exercise the option in almost every case.

    (b) 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.
    (c) 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 obligated to buy or sell 
the stock in question.
    (d) 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 Sec. 220.3(a) of Regulation T, all financial 
relations between a broker and his customer must be included in the 
customer's general account, unless specifically eligible for one of the 
special accounts authorized by Sec. 220.4. Accordingly, the writer, as a 
customer of the member firm, must make a deposit, which is included in 
his general account.
    (e) In order to prevent the deposit from being available against 
other margin purchases, and in effect counted twice, Sec. 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 endorsement 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.
    (f) 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

[[Page 28]]

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.
    (g) 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.
    (h) 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 Sec. 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.
    (i) 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.
    (j) 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.
    (k) 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.
    (l) For the reasons 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 endorses such a contract would be arranging for

[[Page 29]]

credit in an amount greater than the firm itself could extend, a 
practice that is prohibited by Sec. 220.7(a).

[35 FR 3280, Feb. 21, 1970]