Options Volume Increases Substantially Just Before the Ex-date -- Why?

[dragonman]

Quote from rmorse:

Automatic exercise is only for expiration. The open interest lines that are targeted have more than two hundred, and their cost of setting up the trade is very low because of deals with the exchanges and the clearance firms. There are some phlx MM that make a living from this. Also, MM have the ability to buy calls and exercise, even through they are net shrt the line, customers can't. From this you get a lot of back and forth spreads so each trader can be short many ITM calls

Feel free to call me later if you have more questions.

So it seems that the MM exploit an edge they have over public customers (such as being long and short the same position) that comes sometimes at the expense of public customers.

For example, if the "true" open interest (before the MM start their play) is 200 contracts out of which only 20 will not be exercised by individual customers, public customers can expect that there is about 10% chance that they will be able to enjoy the options that are not exercised (based on the random assignment method used by the OCC).

However, if due to the trading between the MM themselves the MM will have 200,000 positions, then the MM increase their chances to "win" the contracts that will not be exercised at the expense of the public customer (since now there will be 200,200 open interest and the market makers own 99.9% of the contracts).

Did I get it right or am I missing something?

See also the following link:
http://www.ise.com/assets/files/abo...ade_Strategies_in_the_US_Options_Industry.pdf

 

[dragonman]

Quote from spindr0:

...As for why do I think the call will drop and the put will rise, have you ever run a pricing model thru an ex-div date?

Of course I did. The stock price drops on the ex-div date, but since the dividend was priced into the call in advance to reflect that drop, on the ex-div date the "drop" has already occurred and therefore the relevant dividend amount is not discounted anymore from the call price (and vice versa regarding puts), and this effect is higher (both regarding calls and puts) with respect to options with 1 delta or close to that.

See also:
http://www.theoptionsguide.com/effect-of-dividends-on-option-pricing.aspx

 

[spindr0]

Quote from dragonman:

Of course I did. The stock price drops on the ex-div date, but since the dividend was priced into the call in advance to reflect that drop, on the ex-div date the "drop" has already occurred and therefore the relevant dividend amount is not discounted anymore from the call price (and vice versa regarding puts), and this effect is higher (both regarding calls and puts) with respect to options with 1 delta or close to that.

How much call premium will fall on the ex-date depends on the amount the stock price drops and where the call's strike price is in relation to the stock price; that is, whether the strike is ITM, ATM or OTM.

The ITM call premium can be expected to drop dollar-for-dollar with the stock. In fact, where the premium includes a high amount of time value due to a high level of implied volatility, the drop in premium can be even greater than dollar-for-dollar. If the ITM call's premium is high enough then the premium's time value component is relatively high, and implied volatility is high.

The ATM call premium will drop, but generally by an amount less than the drop in the stock price. In fact, the drop may not be that great, because as the stock price falls, the ATM call becomes increasingly out of the money.

The OTM call premium, which is all time value, frequently will drop the least, although the percentage of the drop may be the highest.

 

[dragonman]

Quote from spindr0:

How much call premium will fall on the ex-date depends on the amount the stock price drops and where the call's strike price is in relation to the stock price; that is, whether the strike is ITM, ATM or OTM.

The ITM call premium can be expected to drop dollar-for-dollar with the stock. In fact, where the premium includes a high amount of time value due to a high level of implied volatility, the drop in premium can be even greater than dollar-for-dollar. If the ITM call's premium is high enough then the premium's time value component is relatively high, and implied volatility is high.

The ATM call premium will drop, but generally by an amount less than the drop in the stock price. In fact, the drop may not be that great, because as the stock price falls, the ATM call becomes increasingly out of the money.

The OTM call premium, which is all time value, frequently will drop the least, although the percentage of the drop may be the highest.

Thanks for the clarification.