By Jud Pyle, CFA, chief investment strategist for the Options News NetworkShares of Altria Group ( MO) 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.
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.