By Jud Pyle, CFA, chief investment strategist for the Options News Network
are up more than 12% since closing $14.62 on March 3. The stock has had bullish tailwinds ever since March 4, when the company announced price increases. And, of course, Tuesday's monster rally did not hurt.
Today we saw large call volume in the March options. But don't be fooled into thinking this is something related to the fundamentals. This is just an option strategy related to the fact that the stock trades ex-dividend tomorrow.
The MO March 15 calls have traded more than 240,000 times vs. open interest of 11,809. The March 14 calls have traded more than 130,000 times vs. open interest of 3331. The April 14 calls have traded more than 52,000 times vs. open interest of 2321.
With the stock trading around $16.39, down 21 cents, with the rest of the market up a little more than half of a percent on the day, you might ask: "Was this 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 MO will trade ex-dividend tomorrow.
Because the shares will trade ex-dividend, the March 14 and 15 calls and the April 14 calls are technically an exercise. They are technically an exercise because holders of call options do not participate in the dividend. So 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 is because if the calls are an exercise, then that means that if someone is short the calls and long the stock, he or she 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 who is short the MO March 14 calls is long stock against the calls as a hedge.
Say that the calls are worth parity right now, so that is $2.39 with the stock at $16.39. 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 32 cents, the amount of the dividend, to $16.07. The call that the market maker is short also falls by the amount of the dividend to $2.07. 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 32 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 open interest in each of those strikes.
So the volume that we see is 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.
Jud Pyle is the chief investment strategist for Options News Network and the portfolio manager of TheStreet.com Options Alerts. Click here for a free trial for Options Alerts. Mr. Pyle writes regularly about options investing for TheStreet.com.
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."