Don't Be Fooled by Calls in AvalonBay

The REIT's call activity Tuesday may have appeared bullish, but it was nothing more than an arbitrage opportunity.
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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) - Get Report

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.

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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.

Since the market maker is long the stock (a loser in the fall) and short the call (a winner in the decline), it seems that the market-maker has no economic gain. But the market-maker gets to pocket the dividend of 89 cents!

So based on what we just diagrammed, there is clearly a benefit to being short the calls in case any of the open interest fails to exercise. That is all there is to this trade: market makers trying to get short the calls so that they can be a part of the 1,750 contracts of open interest.

So the volume that we see really reflects market makers buying and selling the calls with one another. All of the trades go on the books as opening. The market-makers are smart enough to exercise their calls, and all that is left is anyone who does not exercise.

Investors should be aware of activity such as this so that they do not get fooled into thinking that the options activity will give them some clues about the stock activity. When looking at options activity, particularly deep-in-the-money call (DITM) options, investors should at least be aware of this and other arbitrage activity to make sure that they have a clear picture of the types of risks that people are taking in their stocks.

We see today that the open interest in the January 25 calls is zero, according the OCC's website. So all of the calls were exercised, demonstrating that despite all of that volume, no new open interest was created.

Jud Pyle is the chief investment strategist for Options News Network and the portfolio manager of Options Alerts. Interested, check out a free trial for Options Alerts. Mr. Pyle writes regularly about options investing for

Jud Pyle, CFA, is the chief investment strategist for Options News Network. Pyle started his career in finance in 1994 as a derivative analyst with SBC Warburg. After four years with Warburg, Pyle joined PEAK6 Investments, L.P., in 1998 as an equity options trader and as chief risk officer. A native of Minneapolis, Pyle received his bachelor's degree in economics and history from Colgate University in 1994. As a trader, Pyle traded on average over 5,000 contracts per day, and over 1.2 million contracts per year. He also built the stock group for all PEAK6 Investments, L.P. hedging, which currently trades on average over 5 million shares per day, and over 1 billion shares per year. Further, from 2004-06, he managed the trading and risk management for PEAK6 Investments L.P.'s lead market-maker operation on the former PCX exchange, which traded more than 10,000 contracts per day. Pyle is the "Mad About Options" resident expert. He is also a regular contributor to "Options Physics."