The Securities and Exchange Commission proposed yesterday to allow New York Stock Exchange specialists to hedge their specialty stocks with options. The objective is to add liquidity to the market, reduce the specialists' risks and thus enable the specialists to get better prices for investors.
Specialists buy and sell specific issues of stock on the exchange floor. As brokers, they execute orders for other brokers on a commission basis, and as dealers, trade for their own accounts. Their obligation is to maintain a market for particular stock issues, which can entail buying at a higher price than anyone else is willing to pay and selling at a lower price than anyone is willing to take. They do not deal directly with the public.
An option is the right, but not the obligation, to buy or sell a stock. Options are used to offset price swings of the underlying stock. A put option is the right to sell a stock at a specified price within a given period; it is bought by people who think a stock will go down. A call option is the right to buy a stock; it is bought by those who think a stock will go up.
What the proposal would mean is that a specialist who hedges his purchases with options can narrow the spread on a stock. For example, if the stock were having trouble trading at 20, the specialist would buy it at a discount, say 16, in order not to take a loss when he resold it if the price declined in the meantime. But if the specialist buys the stock, valued at 20, at 18 and hedges with a put option at 18, the most his investment can decline is $2, even if the stock price plummets. So the customer ultimately gets a better price.
Specialists on regional exchanges have been able to hedge for some time. The New York Stock Exchange's first request in 1976 went unanswered because the SEC feared the power of Big Board specialists to manipulate the market. Before the Great Depression, specialists' option pools led to many abuses.
The commissioners decided that times had changed. The biggest changes are the computerized surveillance system and audit trail that allow the exchange to detect unusual trading patterns and to identify the culprits. That system is expected to be in place at the New York exchange by year's end, when options hedging would start.
The SEC staff tried to insert limitations on specialists' trading because they feared the process would be used for speculation, rather than legitimate hedging. But, on a 3-to-1 vote, the commissioners refused to set limits. Speaking for the majority, Chairman John S.R. Shad observed that half of the trading today is done in large blocks of stock, and therefore, even if specialists have advance knowledge affecting stock prices, they no longer can control the market as they once did. A 35-day comment period will follow the proposal's publication in the Federal Register. THE FUTURE IS NOW . . .
Last week the SEC looked into the future when stock trading will be completely automated. It issued a statement encouraging companies that operate over-the-counter automation systems to apply to the SEC for "interpretive relief."
Although these systems technically would be defined as exchanges and therefore subject to securities laws, the SEC said it would grant relief so that the companies don't have to go through as much red tape to operate.
Automation enables an investor with a personal computer to receive information about stocks and to send an execution order over the telephone lines to a discount broker. After reviewing the account, the broker then can execute the order automatically by computer.
The commission, however, wants to make sure the investor knows that the stock prices he receives are 20 minutes old, unless the investor has paid a premium for up-to-the minute quotations. The commissioners also are concerned about the possibility of fraudulent trading by unauthorized persons as well as the broker's diminished ability to determine if the investment is suitable for his client.