Dividend Trade Strategies in the U.S. Options Industry

---

Dividend Trade Strategies in the U.S. Options Industry
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 ìdividend trade.î Not only does this strategy distort market share with millions of contracts, but it also takes advantage of the fact that individual options traders ñ who may lack sophistication or resources ñ 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.


Dividend Trade FAQ

• 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? 
  

A: This significant spike in volume, shown in this chart, was the result of the dividend trade strategy that will be explained below.

• Q: What is the dividend trade strategy?

A: 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 stockís ex-dividend date . 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.

Dividend Trade Example:
For example, Market Maker A will sell 100,000 deep-in-the-money 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 positions .

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.

To Be Continued in Part 2...
"

---

View ISE's post archive >