Dividend Trade Strategies in the US Options Industry

International Securities Exchange
Whitepaper on
Dividend Trade Strategies in
the U.S. Options Industry
March 2010
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Dividend Trade Strategies in the U.S. Options Industry
Key Terms
Assignment
Notification by The Options
Clearing Corporation (OCC) to a
clearing member that an owner of
an option has exercised his rights.
For equity and index options,
assignments are made on a
random basis.
Call Option
An option contract that gives
the owner the right to buy the
underlying security at a specified
price (its strike price) for a certain,
fixed period of time (until its
expiration). The investor who
sells a call option is obligated to
deliver the stock if the call option
is exercised.
Although the U.S. equity options industry reported 3% growth
in 2009, what many industry participants and observers do not
realize is that this growth is solely attributable to an objectionable
trading strategy called a “dividend trade.” Not only does this
strategy distort market share with millions of contracts, but it also
takes advantage of the fact that individual options traders – who
may lack sophistication or resources – will fail to exercise their
deep-in-the-money call options in order to collect a corporate
dividend payment. The purpose of this document is to explain
the mechanics of the dividend trade strategy and its impact on
the U.S. options market by going through a series of frequently
asked questions about the practice that will reveal the true
market dynamics taking place behind volume reported.
Q: In December 2009, options on Verizon traded an
average volume of about 18,000 contracts per day.
On January 5, 2010, volume spiked to over 2 million
contracts but trading activity returned to much lower
levels the next day. What happened?
This significant spike in volume, shown in this chart, was the
result of the dividend trade strategy that will be explained below.
Options Industry Volume in Verizon (Symbol: VZ)
12/18/2009 – 1/20/2010
Deep-in-the-money
A call option is deep in the money
if the price of the underlying stock
is well above the strike price of
the option.
January 5, 2010:
2,104,178
Ex-dividend date
The ex-dividend date is the first
date when buying a stock does
not entitle the new buyer to the
declared dividend. To collect the
dividend payment, the stock must
be owned prior to that date.
Average Daily Volume (ADV) in VZ
12/18/2009 – 1/4/2010:
18,269
Average Daily Volume (ADV) in VZ
1/6/2010 – 1/20/2010:
36,979
Source: OCC
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Q: What is the dividend trade strategy?
Key Terms
Exercise
To invoke the rights granted to
the owner of an option contract.
In the case of a call, the option
owner buys the underlying stock
at the strike price.
Long a call option
The position of the purchaser
(owner) of a call option. Someone
who is long a call option has the
right to buy stock at the strike price
at or before the expiration date.
Long stock position
A position in which an investor
has purchased and owns stock.
Open Interest
The total number of outstanding
option contracts on a given series
or for a given underlying stock.
Short a call option
The position of an option writer
(seller) which represents an
obligation to meet the terms of
the option if it is exercised by its
owner. Someone who is short a
call option is obligated to deliver
stock if the call option is exercised.
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Dividend trade strategies are transacted by market makers who
are trying to capture corporate dividend payments when individual
customers leave deep-in-the-money call options unexercised on
the day prior to a stock’s ex-dividend date1. To capture as much
of the dividend as possible, two market makers enter into an
agreement to trade deep-in-the-money call options back and forth
with each other on the day prior to the ex-dividend date.
For example, Market Maker A will sell 100,000 deep-in-themoney call options to Market Maker B. Then they will reverse the
transaction and Market Maker B will sell 100,000 of the same call
options back to Market Maker A. They will do these trades multiple
times to inflate the open interest in the products. At the end of the
trading day, they each end up long and short the same positions2.
The market makers then exercise all of their long options
positions, resulting in a long stock position. In most cases, their
corresponding short options positions will be assigned and the
market maker will immediately be required to deliver most of
their long stock. This is the key to the strategy. For every options
position that remains short, the market maker does not have to
deliver stock and is able to keep the dividend payment for the
stock that they are long.
Q: How can the market makers engaging in dividend
spread strategies be certain they will remain short on
some of their positions?
This is where the most critical factor for the dividend trade strategy
comes into play. The strategy is based on the principle that some
investors will leave their call options unexercised on the day prior
to the ex-dividend date. The process that The Options Clearing
Corporation (OCC) uses to settle transactions when options are
exercised is random3, so if call options remain unexercised, there
is a corresponding likelihood that investors who are short the calls
will not be obligated to deliver the stock.
If the market makers can remain short on even just a small number
of options positions after the settlement process, they will be
able to collect the dividend payment on the corresponding long
stock positions. Because the market maker is left with a long
stock position that is fully hedged by his short deep-in-the-money
calls, the dividend trade strategy has little risk in a low volatility
environment.
1
In order for an investor to collect the dividend payment, they must own the stock on the day prior to the “ex-dividend
date,” which is often 1-2 weeks before the dividend is actually paid. For an investor to capture a corporate dividend
using an options strategy, options models dictate that deep-in-the-money call options should be exercised on the last
trading day before the ex-dividend date of the stock. This way, the investor will own the underlying security in time to
collect the dividend payment. There are no automatic exercise rules in place for the day prior to ex-dividend dates.
2
The Options Clearing Corporation (OCC) only permits market makers to remain both long and short the same position at
the end of a trading day. Other market participants may not do so.
3
This process is called assignment.
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Q: How does it work?
Here is a simplified example4:
The Scenario (on the day prior to the ex-dividend date)
• Stock XYZ is trading at $50 and will pay a dividend of
$0.10 per share.
• Dividend trade strategies are transacted in deep-in-themoney call options, so in this simplified example, we will
assume that the market makers have agreed to use the
dividend trade strategy in the $40 calls for stock XYZ.
• Open interest in the $40 calls (at the beginning of the trading
day) is 10,000 contracts.
The Dividend Trade Strategy Transactions
• Market Makers A and B trade the $40 calls back and forth
with each other. At the end of the day, they end up with the
following positions in the $40 calls:
Market Marker A
Long positions
500,000
options
contracts
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Short Positions
500,000
options
contracts
Market Marker B
Long positions
500,000
options
contracts
Short Positions
500,000
options
contracts
This step-by-step example is for illustrative purposes.
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The Exercise Process
• In this example, say 90% of market participants in the original
open interest pool exercise their call options. Because open
interest was originally 10,000 contracts, this means that 1,000
contracts remain unexercised.
• Market Makers A and B exercise all of their long options
positions, meaning they are now long the stock.
The Assignment Process
• 1,009,000 call options have been exercised out of a total of
1,010,000 that were outstanding.
• OCC now randomly selects investors who hold short positions
to deliver the stock for each call option that has been exercised.
• An investor who is short the position has a 99.9% chance of
being assigned to deliver the stock (1,009,000 call options
exercised/1,010,000 open short positions).
• That same investor also has a 0.1% chance of remaining short
(1,000 unexercised call options/1,010,000 open short positions).
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The Dust Settles
• Market Maker A has exercised 500,000 call options,
but must turn around and deliver against 99.9% of his
corresponding short calls (499,500 contracts). In the end,
Market Maker A retains a balance of 500 short call options.
He holds stock for 500 of the long call options he exercised
and ends up with 50,000 shares of Stock XYZ (1 option
contract = 100 underlying shares). He collects a dividend of
$0.10 on each of these shares, or $5,000 total.*
• Market Maker B has exercised 500,000 call options,
but must turn around and deliver against 99.9% of his
corresponding short calls (499,600 contracts). In the end,
Market Maker B retains a balance of 400 short call options.
He holds stock for 400 of the long call options he exercised
and ends up with 40,000 shares of Stock XYZ. He collects a
dividend of $0.10 on each of these shares, or $4,000 total.*
• Both market makers have collected the dividend payments
associated with those shares, and both remain fully hedged
with short deep-in-the-money calls. This means they can
trade out of the hedged position (or wait until expiration if it
is near) after they collect the dividend.
*Note: This example is for illustrative purposes only. The dividend payment is offset
by the time premium left in the option, so the full dividend may not be captured.
Q: What happens to the market participants who were
originally short the call options?
The market participants who originally held short call positions
are disadvantaged because they have a much lower chance of
remaining short if the dividend trade strategy occurs. Often times,
these market participants are simply retail or institutional investors
who held a buy-write position5 and wanted the dividend payment
themselves.
Assume Individual Investor A is long 1,000 shares of Stock XYZ
and short 10 in-the-money $40 calls in Stock XYZ. In the original
open interest pool of 10,000 contracts, Individual Investor A would
have had a 10% chance of remaining unassigned and collecting
the dividend payment for his long stock positions if unrelated
investors failed to exercise 1,000 calls (1,000 unassigned call
options out of a total open interest pool of 10,000 contracts).
However, because Market Makers A and B engaged in the
dividend trade strategy, the open interest pool was inflated by
1,000,000 contracts. Now, Individual Investor A only has a 0.1%
chance of remaining unassigned. This means that it is highly likely
that he will be assigned on all of his short positions, will have to
deliver his long stock, and will not be able to collect the dividend
payment. Instead, Market Makers A and B will obtain the dividend
payment that Individual Investor A could have collected.
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A buy-write position is a covered call position in which stock is purchased and an equivalent number of calls is written at
the same time. Example: buying 500 shares XYZ stock, and writing 5 XYZ $40 calls.
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Q: Why doesn’t everyone who owns a deep-in-the-money
call option exercise it?
Most professional investors are aware that they should exercise
their deep-in-the-money call options to collect a dividend. However,
there are many reasons why individual investors may fail to do so.
An individual investor may be unaware that a stock is going exdividend, or they may not have the money to buy the stock.
The dividend trade strategy is based on the principle that less
sophisticated individual investors will fail to exercise their call
options. If everyone exercised their call options, this strategy would
not work. Consequently, market makers will only use the dividend
trade strategy if there is a significant amount of existing open
interest.
Q: Why didn’t dividend trade strategies occur in 2008 to
the degree that they did in 2009?
A low volatility environment is conducive to this type of trading as
it makes this strategy virtually risk free. With low volatility, it is very
unlikely that the stock will move through the deep in-the-money
strike price – where the price of the stock is lower than the strike
price. That is, the position remains hedged. With high volatility
levels in 2008, this strategy was riskier. However, the use of the
strategy returned in 2009 when volatility returned to lower levels.
Q: Why do dividend trade strategies only occur in deep-inthe-money calls?
The strategy only makes economic sense if the strike price for the
option is lower than the trading price of the stock.
Q: Don’t exchange transaction fees make dividend trade
strategies prohibitively expensive?
Dividend trade strategies can only occur if exchange fee caps are
in place. Without fee caps, the cost to transact the strategy would
be far greater than the profit from the dividend payments. ISE has
never supported these types of trades through the use of fee caps,
and as a result, they do not occur here.
Q: Where do these trades occur?
Because these trades are pre-arranged, they are primarily
transacted on floor-based exchanges. The distortion in market
share is clear when looking at the difference in market share
distribution when dividend trades are transacted and when they
aren’t. Take the example of the market share distribution of
options on Verizon. The day prior to Verizon’s ex-dividend date
was January 5, 2010. The charts below show market share by
exchange for the 10 days before January 5, and on January 5:
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Industry Market Share in VZ
12/18/2009 – 1/4/2010
ADV: 18,269
Industry Market Share in VZ
1/5/2010
Volume: 2,104,178
Q: What is the benefit to the exchanges where these
transactions occur?
The only benefit to the exchanges where these trades occur is
inflated volume, and as a result, distorted market share. The trades
create an optical illusion that gives the exchanges where these
trades take place the appearance of liquidity and profitable volume.
Q: Isn’t all volume equal for the industry – regardless of
what type of strategy is being used?
Dividend trade volume is harmful to the U.S. options industry (see
below), and the only benefit is inflated market share when in fact the
volume provides little financial benefit to the exchange and is not
accessible to other market participants.
Q: What impact do dividend trades have on the U.S.
options industry?
• Individual investors who hold buy-write positions have a much
higher chance of being assigned on their short calls – and not
collecting the dividend payment. Market Makers who engage in
the dividend trade strategy step in and capture the dividend
instead.
• Dividend trade strategies do nothing more than “paint the
tape,” creating the appearance of healthy order flow. For the
individual investor who has been trained to associate high trading
volume with news in the individual stock, these trades are very
misleading.
• The strategies distort market share in the U.S. options market,
negatively impacting order flow providers who make routing
decisions based on liquidity.
• The risk of engaging in dividend trade strategies far outweighs
any potential profit for those who participate in these transactions.
If any kind of mistake is made in the clearing process, a clearing
member could be liable for an excessive amount of money. On the
other hand, the dividend payments that are actually collected as a
result of these transactions are relatively small.
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Q: How much money can be captured through dividend
trades?
First, for an exchange, there is very little economic value since fee
caps must be in place for these trades to occur.
In addition, it is important to note that because market makers are
the only industry participants that are permitted to be long and
short the same options position overnight, they are the only group
that can potentially benefit from these transactions. There is a
limited group of market makers who can engage in this strategy,
and their potential profit on this strategy is relatively small.
Because of this, we believe that the risks of this strategy, which
are described above, outweigh any potential profits.
Q: How did dividend trades distort market share in 2009?
The graphs below illustrate the impact. The first chart shows
reported equity options market share by exchange for 2009.
The next chart shows equity options market share for 2009 with
dividend trades excluded from the volume. The difference is notable.
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Q: Should dividend trades be included in industry volume?
We do not think they should. Beyond the fact that the dividend
trade strategy is based on objectionable principles, it is nothing
more than an optical illusion. The liquidity, or appearance of liquidity,
is not accessible to any other industry participants, and it does
not provide economic value for the exchanges where they are
transacted.
Volume from the dividend trade strategy accounted for nearly 13%
of industry-wide equity options volume in December 2009 alone
– a total of nearly 35 million contracts. In fact, when the smoke is
cleared away and dividend trades are removed from industry growth
calculations for 2008 and 2009, the U.S. equity options industry
actually shrunk by 0.1% for the full year 2009 compared to 2008.
Industry ADV in Dividend Trades
Industry ADV in Equity Options
Q: Can dividend trade activity be tracked accurately?
Dividend trades are easy to identify, as the example of the trading
activity in options on Verizon on January 5, 2010, illustrated. ISE’s
calculations are based on a formula that identifies deep-in-themoney call options that are executed in large size on the day prior
to the ex-dividend date of a stock.
Q: What is the SEC’s position on dividend trade strategies?
To date, there are no rules in place that prohibit the trades
from occurring.
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