The SPY Dividend Debacle: Lessons Learned
The SPY Dividend Debacle: Lessons Learned
$SPY (SPDR S&P 500 ETF) went Ex-Dividend last week and an unusually large number of In-the-Money (ITM) options were not exercised to capture the dividend. The main culprit: Bank of America Merrill Lynch. The firm announced on Friday that it suffered a $10 million loss because of a back office error handling the exercise process.
The basic option dividend capturing strategy involves selling or buying deep In-the-Money (ITM) call spreads with the intention of exercising the long side and hoping that not all of the short calls get assigned and that you will collect the dividend for those shares.
The play is take advantage of customers (or clearing firms, in this case) who inadvertently do not exercise the deep in the money calls and thereby forgo collecting the dividend. There are also cases were less knowledgeable investors, or ones without enough equity to cover the underlying share purchases, may keep possession of the calls, which immediately drop in value by the amount of the dividend after the stock goes ex-dividend.
Normally, anywhere from 4%-7% of ITM options go unexercised according to recent studies. According to the Wall Street Journal ‘Trading data released Friday morning indicated that about 24% of the call options on the SPDR ETF went unexercised …’
Let’s take a look at this controversial practice and the ramifications of not exercising deep ITM calls before a large dividend.
Dividends & Early Exercise of Call Options
An option that can be exercised any time during the life of that option. Exercising an option before expiration is called Early Exercise.
European-style option
An option that can be exercised only during a specified period of time.
A common strategy among professional option traders is to sell large quantities of in-the-money calls just prior to an ex-dividend date of an underlying that has a substantial dividend. There are instances where non-professional option traders may not understand the benefit of exercising a call option early, and therefore may unintentionally forego the value of the dividend. The professional trader may only be 'assigned' on a portion of the calls, and therefore profits by receiving a dividend on the stock used to hedge the calls that are not exercised.
Example #1 - Basic Example - IBM @ 100 on the Thursday before March expiration
Dividend= $ 1 Stock Ex dividend the Friday of March expiration
March 70 calls = $ 30- make the assumption that there is no open interest on this line.
Trader A buys 1,000 calls from Trader B @ $30
Trader B buys 1,000 calls from Trader A @ $30
(I want to point out that normally deep in the money call spreads are the way these positions are put on, but for this example let’s just keep it simple - Trader A buys from Trader B and vice versa)
Trader A exercises all his calls- Position is now long 100,000 common & short 1,000 March 70 calls
Trader B neglects to exercise his options- Position is now short 100,000 common & long 1,000 March 70 calls
Let’s see what happens on the next day when the stock opens up after going ex dividend:
Stock opens at $99 after adjusting for the $1 dividend.
Trader A collects $100,000 in dividends. His common position is down $1, but so are his short March 70 calls. Net P-n-L + $ 100,000
Trader B has the unfortunate circumstance due to his negligence of having the opposite position and thus an opposite P-n-L (-$100,000).
It is not uncommon when there is a company with a large dividend that there is enormous activity in the deep in the money calls the day before the stock goes Ex-Div. For this trade to be profitable there must be a large dividend plus a large open interest in the strike price. Traders that do the trade and are banking on some retail customers not exercising their deep in the money call options. The equation or thought process that a trader must take into account when doing the trader is how many options they think might not be exercised. Remember that the trader must pay commissions and exchange fees when doing the trade, so if all the short calls get assigned to the trader then they are out the commissions. This can be very expensive. These Ex-Dividend trades were more prevalent in the early years of equity option trading. As trading becomes more sophisticated and more and more of the volume is institutionally based the chance of non-exercise of these deep call options has become increasingly more remote.
Example #2- Same Basic Example but a week before expiration, - IBM @ 100
Dividend= $ 1 Stock Ex dividend.
March 70 calls = $ 30- make the assumption that there is no open interest on this line.
Trader A buys 1,000 calls from Trader B @ $30
Trader B buys 1,000 calls from Trader A @ $30
Trader A exercises all his calls- Position is now long 100,000 common & short 1,000 March 70 calls
Trader B neglects to exercise his options- Position is now short 100,000 common & long 1,000 March 70 calls
Let’s see what happens on the next day when the stock opens up after going ex dividend:
Stock opens at $99 after adjusting for the $1 dividend.
Trader A collects $100,000 in dividends. His common position is down $1, but so are his short March 70 calls. Net P-n-L + $ 100,000
Trader B has the unfortunate circumstance due to his negligence of having the opposite position and thus an opposite P-n-L (-$100,000).
BUT,
Key Point-There is a residual position after this trade-
Trader A - Position is now long 100,000 common & short 1,000 March 70 calls- Synthetic Short 1,000 Mar 70 Puts
Trader B - Position is now short 100,000 common & long 1,000 March 70 calls-Synthetic Long 1,000 March 70 Puts
The following week IBM goes to $50. What is the consequence of this fall?
Trader A- P-n-L (-$200,00(on movement)- +$100,000(on dividend play = Net P-n-L of -$100,000) Synthetic Short Puts -The position breaks even until the underlying breaks through 70, where the trader is now naked long 100,00 common.
Trader B- Net P-n-L (+ $100, 00) Synthetic Long Puts-
The position breaks even until the underlying breaks through 70, where the trader is now naked short 100, 00 common.
The relevance of this example is to show that the trader must be aware of possible unintended consequences of this seemingly risk free trade. In order for a trader to consider doing this trade with the deep in the money calls, one must first see where the price that the puts on that strike price are trading. If the dividend is greater then the price of the puts, then the trade may be worth doing.
Example #3 - In order to avoid what happened in Example 2 to Trader A: Trader A is long 100,000 common & short 1,000 March 70 calls- Synthetic Short 1,000 Mar 70 Puts. As soon as the underlying opens the next day he could go into the open market and buy 1,000 Mar 70 puts at, for example .20cents. He then is fully hedged and has locked in .80 cents on the overall trade.
Conclusion
Normally, a trader very rarely exercises equity call options because doing such has the consequence of having them now owning the common and having to pay interest. There are, however exceptions to this rule as discussed above and there are also other more complex instances where it may be appropriate to early exercise call options. The most obvious would be when an underlying becomes hard to borrow and the trader is receiving no interest (or even paying interest to be short the underlying). In that case, it would be prudent to exercise the calls to become flat or even long the stock. In conclusion, it is imperative for any trader to fully understand all the possible ramifications and outcomes of early exercise of call options before it is too late and the early exercise has caused damage to the trading account.
Keep informed………
Disclaimer
We are not liable for any trading decisions made by any reader. NO advice is given or implied. The information offered in this article is for demonstration purposes ONLY and should not to be either construed as an offer or considered to be a recommendation to buy or sell any options.
Your use of this information is entirely at your own risk. It is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. You must assess the risk of any trade with a professional broker, or financial planner, and make your own independent decisions regarding any trades mentioned herein. This is not a solicitation to buy or sell any options, or to purchase or sell any credit spreads. Trading options only carries a high degree of risk, is not suitable for all traders/investors, and you may lose all of your premium money invested in the options. If you have never traded options before, we strongly recommend that you read a little background information made available by the government. Only you can determine what level of risk is appropriate for you. Also, prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.
Past performances DO NOT guarantee future results. Please consult with your own independent tax, business and financial advisors with respect to any trade. We will NOT be responsible for the consequences of anyone acting on this purely demonstration material.
Important Note: Options involve risk and are not suitable for all investors. For more information, please read the Characteristics and Risks of Standardized Options.
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