Dividend Trade Strategies in the U.S. Options Industry, Part 2

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To read part one of this series, please click here.

Dividend Trade FAQ, continued

• Q: How can the market makers engaging in dividend spread strategies be certain they will remain short on some of their positions?

A: 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 random, 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.

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• Q: How does it work?

Here is a simplified example:

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-the-money 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
(click to enlarge)



The Exercise Process
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The Assignment Process
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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 $5000 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 $4000 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.

More to come in Part 3....
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