Dr. Kearney’s Option Clinic: Option Volume with “Dividend Play” Strategy Distorts Picture

Tuesday saw a spike in option volume on two stocks – Verizon (VZ) and AT&T (T). When I say spike, I mean a SPIKE! The 13 most active option strike prices Tuesday were call strikes in either VZ or T. Those 13 call strikes traded in excess of 7 MILLION contracts. The T April 30 call with an open interest of ~32,600 contracts, traded in excess of 1 million contracts. Other strike prices in T & VZ were active also. 

What’s going on? A takeover, merger, corporate action? Should I get long either the stock or call options of one or the other, or both? A decision to get long is of course up to you, but in this case a jump in option volume is for a very different reason: the quarterly dividend of T & VZ.

There is an arbitrage strategy used by professionals to capture dividends, it is known as the "Dividend Play". Let’s use XYZ at $50 per share. It goes x-dividend by $0.20 per share (x-d means investors buying shares in XYZ on or after the "X date" are not entitled to the dividend) today April 7th. Traders yesterday, April 6th are looking at the size of the dividend ($0.20), the open interest of the April 40 and 45 strike calls, and compute the cost of owning stock between now and April Expiration, Friday April 15th. Option open interest in the XYZ April 45 calls is fairly high. The interest rate for $5,000 for 9 days (April expiration) is ~$0.02. The dividend is $0.20.

 Here’s what happens (this type of trade is commission intensive, margin intensive, and not an investor friendly strategy): A floor trader (Trader A) will buy 1,000 of the April 40 calls at $10.00, and sell 1,000 of the April 45 calls at $5.00. "What"? Hang on, there’s more. Trader A will exercise all 1,000 of the 40 strike calls, the other trader who bought the 45 strike calls will exercise 1,000 of the 45 calls. Trader A is short 1,000 of the 45 strike calls, but the Options Clearing Corp assignment process is on a random basis.  Trader A is hoping that he or she will not get assigned on all of their short 45 calls. Some investors or traders who own the April 45 strike calls are either unaware of the dividend, or choose not to exercise the option early.

Let’s assume that Trader A only had 900 of the short 45 calls assigned. He exercised 1,000 of the 40 strike calls, 900 long and short options offset each other, so that trader is now long 10,000 shares (this is the net 100 long contracts exercised) and short 100 of the 45 strike calls. If the $50 stock opens unchanged (X-D), it will be at $49.80 X-D. The short 45 strike calls are $4.80 in-the-money, but trader A will receive $0.20 per share on 10,000 shares on the payable date. The $0.20 is not all profit, as there were transaction costs, and the trader will pay 9 days of interest on the long stock, near $50 per share. Trader A is thinking "If I can make maybe ~$0.10 per share on 10,000 shares after all expenses, I just made $1,000". Trader A is at risk for the next 9 days, because the 100 short 45 strike calls will only protect him down to the $45 level. Remember he has an In-The-Money "Covered Write" position on with long stock and short a call.

So by seeing huge option volume would it have been wise to buy shares the following day in T & VZ? T was up a little X-D, while VZ was off about $0.05 that next day. The Dividend Play is not an indicator of anything, other than a stock going X-D. some investors think a jump in option volume in one day means there is going to be wonderful liquidity in those options. Trader A’s is hoping his short 45 strike calls get assigned in 9 days, leaving him with no stock or option position after April expiration. He might not trade those options again for another 3 months.

The next time you see big option volume in several strikes of In-The-Money calls, see if the stock is going X-D the following day. 

I’d love to hear your thoughts on the dividend play. I might talk more about this next week.