With the Apple (AAPL) dividend approaching, traders will likely see a large amounts of deep in the money call buying in near term months. We can see the activity in the regular February contract between the 260 and 425 strikes:

AAPL Options Chain

These are not 'bullish bets.' These are dividend plays on the \$2.65 dividend that goes ex-dividend tomorrow. Basically, professional paper is trying to take advantage of non-professional paper forgetting to exercise deep in the money options on the stock. A while back I wrote up on our Option Pit Blog describing how dividend plays work using Bristol Myers Squibb (BMY) as an example. At the end I ask (rhetorically) if retail traders should attempt to execute this trade, and the answer is no. However, retail traders need to be aware of this play because if they do not exercise their AAPL calls today, they will lose out on \$2.65 of wealth. At the end of the piece I give a helpful short cut for traders to tell whether they should exercise their call.

Here is the piece I wrote:

The Explanation:

First the synthetics behind the dividend play. As we all know: Call-Put=Underlying-Strike Price+ (Cost of Carry). In European style options this always holds true. In American style options though, this can get out of whack. For example, BMY is about to go ex-dividend on \$0.33 tomorrow. With the stock closing at \$26.85 the 26 strike looks like this:

If we run the put-call parity formula something in this equation doesn't add up:

.85-.25=26.85-26+ (-33)

How can 0.6 = 0.5? The answer is it can't. The 26 calls must be exercised to collect the dividend. In theory a trader that is holding these calls should exercise them, thus buying the stock and buying the corresponding put at the same time creating the synthetic call (in practice, most pros just exercise the calls). If he or she does not, the holder of those calls will lose \$0.10 of wealth per contract.

As of tomorrow, the formula will line up again when: .75-.25=26.5-26+ (0) (if you are wondering where I got a \$0.75 value for the call, multiply the dividend by the delta of the put when BMY opens at \$26.50 tomorrow), a situation where .50=-50. If a trader does not exercise his or her call, there is a transfer or wealth from the holder of the long call, to the person that did not get assigned on his or her call option of \$0.10.

If this type of math didn't exist I could buy the stock, buy the put, sell the call and collect the dividend risk free in a trade called a conversion. But, because of put-call parity and American style options, I can get my stock taken away. Essentially, the call and the synthetic call always need to line up or I should exercise/be assigned on the call option.

If this all sounds a little confusing; here is a short cut for those that do not want to do the math: If (I-d) is greater than the value of the put the call should be exercised.

The Execution:

The general public needs to understand one thing. Net positions are not settled up until the end of the day. Therefore it is possible to buy a call and immediately exercise it, even if I am net short calls. Basically if I am short 200 calls that are in the money, and on a given day buy 200 calls, if it is before 5:00 PM Eastern Time I can exercise the 200 calls I purchased.

If traders know one thing it's that there are a lot of times customers forget to exercise calls into a dividend. So being savvy, we try to take advantage of customers forgetting to exercise calls. We will find a stock that has a high dividend. I would then walk into the crowd and sell someone a very large amount of calls on a line that has high open interest, typically about 10x the open interest. Then, the trader I just sold calls too would look at me and sell me the same calls in the same number at the same price. We would then both exercise the calls 'bought today.'

You can see a clear example that happened today in BMY. Notice how many calls got put up on the April 25 and 26 strikes:

As an example, a trader may have bought and sold the BMY April 25 calls for \$1.85 1000 times. The trader will make \$33.00 per contract that he or she is not assigned on tomorrow. Thus, if the trader is short 50 of these contracts in the morning he or she will have an extra \$1650.00 in their pocket. As long as the amount collected is greater than the transaction cost, the trader is a winner.

It will be interesting to see how well this dividend play worked. We will know if it was a success based on the amount of open interest that is left on those strikes tomorrow. The closer to zero at tomorrow's open interest, the worse that dividend play worked for the traders.

UPDATE, the trader's that traded the 26 strike got a lot of options through, check out the open interest on the 26s vs. the 25s and 24s:

Should retail traders do dividend plays?

No, the execution costs are too high for this trade to ever work. However, it is important to understand that this play occurs; otherwise one might get the wrong idea when they see a call to put ratio in BMY that looks like this:

How do I know if I should exercise my calls?

You can run the Put-Call parity formula and if it comes up not equating, the options are an exercise. However, there is a short cut that I use. Generally speaking, for any option that has less than 30 days to expire, if one is long a call on a strike, if the dividend is greater than the value of the corresponding put, the call is an exercise.

Here is an example using AAPL:

Notice the \$2.65 dividend is greater than the value of the put on the 425 strike, thus, the AAPL February 425 calls are probably an exercise. For options outside of 30 days, I would suggest doing the full formula, however, as interest for the long stock comes into play. If you are confused, call your broker, they will have someone that can advise you toward the proper course of action.