TSC Options Forum: Capturing the Dividend

I read your note in the CC conversation regarding Bank of America, which said its "options are leading the most actively traded. As the shares go ex-dividend tomorrow, volume is most likely being driven in by an arbitrage play to qualify for the 80-cent quarterly payment."

Would you be kind enough to explain to those of us with just a beginning understanding of options, how it is that traders are goosing returns a bit with a trade like this? I'm especially interested if it seems to be happening regularly with some of the larger dividend stocks out there. If you could throw together a quick story, I think many of us would find it interesting.

Thanks,

-- Brian

Many readers this week asked for an expanded explanation regarding that Columnist Conversation post.

The process of trying to capture the dividend payment works something like this: The day before a stock goes ex-dividend (which means a security that no longer carries the right to the most recently declared dividend), an option trader will sell in-the-money calls short against either long stock or another in-the-money call, essentially establishing a neutral position. The trader is hoping that the short calls will not be assigned (forced to sell out the long position) on the short call, and will then be in a position to both collect the dividend and take part in the accompanying decline in the share price.

A look at the Bank of America(BAC Quote) numbers will help explain the process. The company pays an annual dividend of $3.20, or 80 cents a quarter. Let's assume you purchase 10,000 shares (or 100 in-the-money calls that you plan on exercising) on Tuesday, at $76.50, and simultaneously sold 100 January 70 calls at $7.60.

On Wednesday morning, when the stock goes ex-dividend, you can expect the share price, all else being equal, to be reduced by 80 cents, which would cause the January 70 call to decline by a commensurate amount. This means if -- and it's a mighty big if -- for some reason the call is not assigned, the position would ostensibly garner the bulk of the 80-cent dividend risk-free. The profit can then be locked up by creating a conversion through the purchase of January 70 puts.

But there's no secret to this strategy. The people making this play, which is almost exclusively done by professionals and institutional traders, are simply taking a shot that someone will forget to exercise their in-the-money calls.

"A few years ago you might have gotten away with some unassigned calls," said Adam Warner, a proprietary options trader and contributor to Street Insight, "but now most option traders are pretty sophisticated."

While there may be a few retail traders that simply forget, or for whatever reason choose to not exercise their in-the-money calls, it's highly improbable that "smart money" will suddenly succumb to group amnesia and forgo the dividend payment.