Dividend Plays Using Options
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With the Apple (AAPL) dividend approaching, traders will likely see a large amounts of deep in the money call buying in near term months. We can see the activity in the regular February contract between the 260 and 425 strikes:
These are not 'bullish bets.' These are dividend plays on the $2.65 dividend that goes ex-dividend tomorrow. Basically, professional paper is trying to take advantage of non-professional paper forgetting to exercise deep in the money options on the stock. A while back I wrote up on our Option Pit Blog describing how dividend plays work using Bristol Myers Squibb (BMY) as an example. At the end I ask (rhetorically) if retail traders should attempt to execute this trade, and the answer is no. However, retail traders need to be aware of this play because if they do not exercise their AAPL calls today, they will lose out on $2.65 of wealth. At the end of the piece I give a helpful short cut for traders to tell whether they should exercise their call.
Here is the piece I wrote:
First the synthetics behind the dividend play. As we all know: Call-Put=Underlying-Strike Price+ (Cost of Carry). In European style options this always holds true. In American style options though, this can get out of whack. For example, BMY is about to go ex-dividend on $0.33 tomorrow. With the stock closing at $26.85 the 26 strike looks like this:
If we run the put-call parity formula something in this equation doesn't add up:
How can 0.6 = 0.5? The answer is it can't. The 26 calls must be exercised to collect the dividend. In theory a trader that is holding these calls should exercise them, thus buying the stock and buying the corresponding put at the same time creating the synthetic call (in practice, most pros just exercise the calls). If he or she does not, the holder of those calls will lose $0.10 of wealth per contract.
As of tomorrow, the formula will line up again when: .75-.25=26.5-26+ (0) (if you are wondering where I got a $0.75 value for the call, multiply the dividend by the delta of the put when BMY opens at $26.50 tomorrow), a situation where .50=-50. If a trader does not exercise his or her call, there is a transfer or wealth from the holder of the long call, to the person that did not get assigned on his or her call option of $0.10.
If this type of math didn't exist I could buy the stock, buy the put, sell the call and collect the dividend risk free in a trade called a conversion. But, because of put-call parity and American style options, I can get my stock taken away. Essentially, the call and the synthetic call always need to line up or I should exercise/be assigned on the call option.
If this all sounds a little confusing; here is a short cut for those that do not want to do the math: If (I-d) is greater than the value of the put the call should be exercised.
The general public needs to understand one thing. Net positions are not settled up until the end of the day. Therefore it is possible to buy a call and immediately exercise it, even if I am net short calls. Basically if I am short 200 calls that are in the money, and on a given day buy 200 calls, if it is before 5:00 PM Eastern Time I can exercise the 200 calls I purchased.
If traders know one thing it's that there are a lot of times customers forget to exercise calls into a dividend. So being savvy, we try to take advantage of customers forgetting to exercise calls. We will find a stock that has a high dividend. I would then walk into the crowd and sell someone a very large amount of calls on a line that has high open interest, typically about 10x the open interest. Then, the trader I just sold calls too would look at me and sell me the same calls in the same number at the same price. We would then both exercise the calls 'bought today.'
You can see a clear example that happened today in BMY. Notice how many calls got put up on the April 25 and 26 strikes: