Dividend Trade Strategies in the U.S. Options Industry, Part 3

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To read part one of this series, click here.

For part two, click here.

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.

• Q: What happens to the market participants who were originally short the call options?

A:  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 position 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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• Q: Why doesnít everyone who owns a deep-in-the-money call option exercise it?

A:  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 ex-dividend, 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 didnít dividend trade strategies occur in 2008 to the degree that they did in 2009?

A: 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 ñ 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-in-the-money calls?

A:  The strategy only makes economic sense if the strike price for the option is lower than the trading price of the stock.

• Q: Donít exchange transaction fees make dividend trade strategies prohibitively expensive?

A:  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: What impact do dividend trades have on the U.S. options industry?

Dividend trade strategies are harmful to the U.S. options industry:

• Individual investors who hold buy-write positions have a much higher chance of being assigned on their short calls ñ 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 ìpaint the tape,î 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.

• 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.

Part four, the final installment of this series, is next...
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