Don't Be Fooled by Calls in AvalonBay

Financial stocks got a lot of press in 2008, and rightly so. The meltdown impacting the economy is hitting the financial stocks hard. Real estate investment trusts, or REITs, have also been pounded, as it is real estate that helped bring us to our knees.

But Tuesday we saw some call activity in AvalonBay Communities (AVB Quote) that on the surface looked bullish, but in actuality was nothing more than an arbitrage opportunity and not a sign of bottom-fishing.

Let's look at the activity. Yesterday, the AVB January 25 calls saw volume of more than 14,000 contracts, vs. open interest of just 1,750. With the stock trading around $60.50, down more than $1.25 on the day, you might wonder if this activity was caused by a bullish investor buying calls that are way in the money instead of buying stock. Or, was it a bearish investor selling calls rather than shares?

The answer in fact is neither. This trade is neither bullish nor bearish. Instead, it was a trade designed to take advantage of the fact that shares of AVB will trade ex-dividend today. As the shares will trade ex-dividend, the Jan. 25 calls are technically an exercise. because holders of call options do not participate in the dividend. Rather than hold the calls, the owner of the calls should exercise them and get the shares, and get the dividend.

So why all of the volume in the calls? Well, the answer lies here: If the calls are an exercise, then that means that if someone is short the calls and long the stock, they can make a profit on any call that is not exercised. What do I mean by that? Well, think of it this way. Any option market maker that is short the AVB Jan. 25 calls is long stock against the calls as a hedge.

Say that the calls are worth parity right now, so that is $35.53 with the stock at $60.53. If the calls that the option market-maker is short are not exercised, then the stock will fall by the dividend amount. So the stock in this case falls by 89 cents, the amount of the dividend, and the stock falls to $59.64. The call that the market-maker is short also falls by the amount of the dividend to $34.64.