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

[dragonman]

Hi, I noticed that sometimes the call options volume regarding ITM calls increases substantially in the day before the ex-dividend date. For example, on November 14, 2011, the day before MSFT's ex-date, the volume for the January 2012 15 call was 396,000 contracts.

In general, when the regular daily volume is a few hundreds contract the volume in the day before the ex-date regarding specific ITM strikes can increase substantially to thousands, ten thousands, or even hundreds thousands (as was the case regarding MSFT).

Also, on the ex-date itself the open interest usually does not increase by such huge amounts which may indicate that the option contracts that were heavily traded on the day before the ex-date were either closed out in the market or exercised/assigned.

I am sure there should be a good reason for such an increase in volume -- it does not seem like a usual trading activity by retail customers or market makers. I would be happy to read any ideas. Thanks!

 

[rmorse]

Dividend Spreads. Market makers look at the open interest on ITM calls with high dividends. They short large volumes of the ITM calls where the dividend is worth more than the put value, hoping the owner of the call will not exercise. They will keep their buy write on and receive the dividend on the stock and keep the short call for protection.

 

[spindr0]

Dividends are priced into the options. With ATM options, it's spread evenly across both puts and calls. The more and option is ITM, the greater the ex-div effect on that option. IOW, if looking at a strike 5 pts higher than the UL, that call will drop more than the same strike put will rise. Because of this, ITM call owners tend to close prior to ex-div. If that selling causes ITM calls to trade below parity, they get arbed. It's likely that there are other reasons as well.

There are 4 scenarios that affect open interest. If OI isn't increasing then buying and selling to close is offsetting selling and buying to open, either outright or via assignment/exercise.

 

[OneChicago]

Dividend Trade Volume

Dividend trade strategies are transacted by certain market makers who try to capture corporate dividend payments when individual customers leave deep-in-the-money call options unexercised on the day prior to a stock’s 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. They take advantage of the fact that individual options traders will fail to exercise their deep in-the-money call options in order to collect the corporate dividend payment themselves. While most professional investors are aware that they should exercise their deep-in-the-money call options to collect a dividend, there are many reasons why individual investors may fail to do so. As a result, individual investors who hold buy-write positions have a much higher chance of being assigned on their short calls – and not collecting the dividend payment. Market Makers who engage in the dividend trade strategy step in and capture the dividend instead, while distorting volume with millions of contracts.


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The above is from the ISE website.

Best

 

[dragonman]

Quote from rmorse:

Dividend Spreads. Market makers look at the open interest on ITM calls with high dividends. They short large volumes of the ITM calls where the dividend is worth more than the put value, hoping the owner of the call will not exercise. They will keep their buy write on and receive the dividend on the stock and keep the short call for protection.

I assume you meant "...the dividend is worth more than the CALL value" (and not the put). Please correct me if I am wrong.

Also, do the market-makers short the calls while simultaneously buying the stock (so it's basically DITM covered call)?

In addition, what indication do the market-makers have regarding a call that will not be exercised (if any)? If they are wrong in their prediction that the call will not be exercised, they will not earn anything from their trade, isn't it?

You also noted that they will keep the short call for protection. However, on the ex-date the call price will jump approximately by the dividend amount (since it's a DITM call) and if they want to close the covered call position they will not be able to do that for a profit (since they shorted the call and the new call price will offset the profit from the dividend) -- so I do not understand what kind of protection it provides, I appreciate if you can elaborate.

 

[dragonman]

Quote from spindr0:

...IOW, if looking at a strike 5 pts higher than the UL, that call will drop more than the same strike put will rise. Because of this, ITM call owners tend to close prior to ex-div...

IMO on the ex-date the call price will rise and the put price will drop, and this effect will be greater regarding DITM options (both puts and calls). Why do you think the call will drop and the put will rise?

I think that ITM call owners tend to close prior to the ex-date since the dividend is worth more than the option value, as was noted by rmorse, isn't it?

 

[dragonman]

Quote from OneChicago:

Dividend Trade Volume

...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. They take advantage of the fact that individual options traders will fail to exercise their deep in-the-money call options in order to collect the corporate dividend payment themselves...

Why would market-makers agree to trade the DITM options back and forth between themselves? I do not understand what can they earn from such an operation. For example, let's say that the open interest for DITM call is 200 contracts out of which only 20 contracts are held by individuals that are not going to exercise the calls. Even if the market-makers trade large volumes on this DITM call on the day before the ex-date it will not change the fact that there will still be only 20 "attractive" call options, and all of the volume will represent positions that are opened by the market-makers themselves and therefore these positions will be exercised on the ex-date (as opposed to the 20 individual customers that do not plan to exercise). Could you please explain further?

Moreover, since the OCC uses automatic exercise for options that are in the money why would an individual customer not exercise his option (he does not have to remember to do that, and he actually have to opt-out if he does not want to exercise).

 

[rmorse]

Quote from dragonman:

Why would market-makers agree to trade the DITM options back and forth between themselves? I do not understand what can they earn from such an operation. For example, let's say that the open interest for DITM call is 200 contracts out of which only 20 contracts are held by individuals that are not going to exercise the calls. Even if the market-makers trade large volumes on this DITM call on the day before the ex-date it will not change the fact that there will still be only 20 "attractive" call options, and all of the volume will represent positions that are opened by the market-makers themselves and therefore these positions will be exercised on the ex-date (as opposed to the 20 individual customers that do not plan to exercise). Could you please explain further?

Moreover, since the OCC uses automatic exercise for options that are in the money why would an individual customer not exercise his option (he does not have to remember to do that, and he actually have to opt-out if he does not want to exercise).

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.

 

[spindr0]

Quote from dragonman:

IMO on the ex-date the call price will rise and the put price will drop, and this effect will be greater regarding DITM options (both puts and calls). Why do you think the call will drop and the put will rise?

I think that ITM call owners tend to close prior to the ex-date since the dividend is worth more than the option value, as was noted by rmorse, isn't it?

Why would ITM call owners tend to close prior to the ex-date if "on the ex-date the call price will rise and the put price will drop"? If it was the case that call values would rise, everyone would be buying calls in order to make an easy buck.


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?

 

[rmorse]

The open interest after the x-date from options that are clearly an exercise is often created from long unhedged option buyers that either don't want to own the equity or lack the capital to exercise.