Last week, we saw a number of large-cap, dividend-paying companies trade ex-dividend. This typically quarterly event can spark huge volume in the options of the specific companies. Ex-dividend literally means new investors in the underlying are not entitled to the next dividend payment. In other words, the point has past to secure oneself as a shareholder of record.
With stock dividends, the payment is made to holders of the stock on what is known as the record date. Since stock settles in three business days, the ex-date is three days prior to the record date. IBM IBM traded ex-div on August 6 with a declared dividend amount of 65 cents. Again, since the stock is now trading without the dividend, the typical price action on the open for an unchanged stock is a decline by the dividend amount, or 65 cents in IBM’s case.
Option holders are not entitled to dividends. This is why in-the-money call options (in most cases) are only exercised on the day prior to the ex-date (and on expiration day of course). This leads to a professional trade called the dividend play, which can cause an explosion in volume in the in-the-money call options with existing open interest, which theoretically should be exercised. It is important to understand the mechanics of this, even if you would not try this play yourself.
The goal for market pros is to take advantage of long call holders that might not exercise for the dividend. They are attempting to create a situation where they are long the stock (and receive the dividend payout) while being simultaneously short an equal amount of in-the–money, high-delta calls. This strategy will have little delta exposure to the stock price as the short call offsets the long stock.
Using IBM as an example, the August 120 calls during Thursday’s trading session traded more than 84,000 contracts! The August 125 calls traded a whopping 109,000 contracts! It appears as though traders shorted these options and bought the stock. Or they bought or sold the call spread and exercised their long call option Thursday night, securing a long stock position ahead of the ex-date. The stock dropped 65 cents from the dividend ex-date Friday morning, causing the calls to drop a similar amount. However, because the trader is long the stock, he will receive that 65 cents back on the dividend payment date in the future. The long call holder doesn’t have any dividend payment coming.
For the full day, here is how the stock and options performed if they remained short the options:
This trade is called shorting into the “pool.” The pool is the open interest. This is a winning trade if some of those open contracts are not exercised. In this case, the 120 call Monday morning only has open interest of 551 contracts! The 125 call strike has only 1,391 contracts left in open interest! Not much potential profit here!
In no way am I recommending this strategy for retail investors as it can lead to a huge commission bill and not many short contracts left on after the exercise–and-assignment wheel dust settles. But you can see that if you were short this call option vs. long stock, there is very little chance that you would not have been assigned Thursday night and your long stock would have likely been called away from you.
Photo Credit: mikelao26
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