CHICAGO -- By Jud Pyle, CFA, chief investment strategist for the Options News Network

Shares of ConocoPhillips ( COP) have rallied 28% since reaching a 52-week low of $35.13 at the beginning of March, and the stock has seen a bullish tail wind throughout the last few weeks. We saw large call volume in COP August options the day before the company announces second-quarter earnings, but don't be fooled; this is just an option strategy related to the fact that the stock trades ex-dividend today.

The COP Aug. 38 calls traded more than 117,500 times, and the Aug. 37 calls changed hands nearly 74,000 times yesterday. The Aug. 38 calls dropped 33 cents on the day and were home to open interest of 4,000 contracts. The Aug. 37 calls dropped 35 cents and were home to open interest of 2,600 contracts yesterday. COP shares closed down 35 cents to $44.90, and the company announced its second-quarter earnings figures at 8:30 a.m. EDT today.

You might be asking: 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?

Answer: Neither. This trade is designed to take advantage of the fact that shares of COP will trade ex-dividend today. As a result, the Aug. 37 and Aug. 38 calls are technically an exercise because holders of call options do not participate in the dividend. Instead of holding the calls, the owner of the options should exercise them and get the shares, thus getting the dividend.

So why all of the volume in the calls? Well, the answer is, 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 who is short the COP Aug. 37 calls is long stock against the calls as a hedge.

Say that the calls are worth parity right now, so that is $7.90 with the stock at $44.90. 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 47 cents (the amount of the dividend) so the stock falls to $44.43. The call that the market maker is short also falls by the amount of the dividend to $7.43.

Since the market maker is long the stock (a loser in the drop) 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 47 cents!

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. The open interest this morning in the Aug. 37 calls is 207 contracts, and the open interest of the Aug. 38 calls is 113 contracts.

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. 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.

Investors should be aware of activity like 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 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.

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."

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