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
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
, "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.
The numbers pretty much bear this out. Entering Tuesday morning, the January 70 call had open interest of 22,000 contracts. Tuesday's volume in the strike was more than 120,000 contracts. But by Thursday morning, open interest stood at just 2,200 contracts, meaning that only 1.8% of the dividend capture volume "got away" unassigned.
(It's worth noting that other in-the-money call options with December or January expirations also traded tens of thousands of contracts on Tuesday, only to see their open interest all but cleared out through assignment the following day.)
But is this process really worth the trouble?
"The strategy does not make much sense to me," Warner said. "Assuming you do get away with some calls, now you need to purchase the put for about 30 cents, the cost of carry to hold the position until expiration is another 13 cents, bringing the profit down to 37 cents."
Factoring in the commissions involved in a three-transaction trade, applying the costs involved with selling the 98.3% of the calls that did not squeak through unassigned, and you've probably brought the real profit down to 10 cents to 15 cents. Then, considering that you'll be tying up significant capital for about seven weeks, it all hardly seems worth the effort.
So why have professionals been gravitating toward this kind of play with increasing frequency?
"There is so little volatility and so little edge
in terms of bid/ask spreads or pricing discrepancy, that guys are reaching deeper into the bag of tricks for ways to generate some income," concludes Warner.
For large institutions, this dividend grab may basically amount to little more than a risk-free shot in the dark and, maybe more important, a good way to look busy. Life on an options desk is not so glamorous or easy these days.
column prompted many readers to ask where they can find free and easy information on implied and historical volatility. Here again, is the link to the
Web site that I included in the article.
On that note, I invite everyone to email me their favorite options books, Web sites, software, brokerage firms and any other resources they have found useful or enlightening. I'll post a consolidated list of (Steve Smith-approved) recommendations as our holiday gift to each other.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to