please help decipher this strategy

xtraderx · Dec 22, 2003

read it in barons, the strategy was presumably to capture dividends, but the mechanics were not clear. here is the excerpts:

"Take altria for example which will pay on 1/9 a quarterly dividend of 68 cents a share. last wednesday was teh last day for div seeking investors to enter teh position b/c it went ex on thurs. so with altria near 54 on weds, option traders began buying large numbers of deep in the money calls, dec 40 calls, that they might excercise to buy stock. tehy focused on cheap short term calls that were about to expire to minimize the time premium paid.

at teh same time, these traders would also sell a similar number of in the money calls with a different strikem say dec 45, to cap their risk and neutralize exposure. here, traders hope fervently to avoid assignment on at least soem of the sold calls, thereby allowing them to snag the div."

what am i missing, how would they get the div? and what are teh particulars of this strategy, pros cons, etc...

thanks

Maverick74 · Dec 22, 2003

Quote from xtraderx:

read it in barons, the strategy was presumably to capture dividends, but the mechanics were not clear. here is the excerpts:

"Take altria for example which will pay on 1/9 a quarterly dividend of 68 cents a share. last wednesday was teh last day for div seeking investors to enter teh position b/c it went ex on thurs. so with altria near 54 on weds, option traders began buying large numbers of deep in the money calls, dec 40 calls, that they might exercise to buy stock. tehy focused on cheap short term calls that were about to expire to minimize the time premium paid.

at teh same time, these traders would also sell a similar number of in the money calls with a different strikem say dec 45, to cap their risk and neutralize exposure. here, traders hope fervently to avoid assignment on at least soem of the sold calls, thereby allowing them to snag the div."

what am i missing, how would they get the div? and what are teh particulars of this strategy, pros cons, etc...

thanks

Yeah this is a very simple div play. Here is what they are doing. They are buying deep in the money calls because that is similar to buying long stock. They are then shorting an equal amount of in the money calls. What they do is when the stock goes ex-div they exercise their calls the night before thereby being long stock. The next day they have a long stock position and short call position or a buy write. They collect the cash dividend from the long stock. Now two things will happen. What they are hoping for is that a lot of people forget to exercise their calls ex-div, believe it or not they do, if they do, the calls will drop by the amt of the dividend and they will essentially earn the div risk free. Not a bad play.

If they do get exercised, they are simply flat, they will have long stock and collect the dividend but then they will owe it back on the short calls so they will break even on those. See here is the idea. Lets say a trader does 1000 of these. He might breakeven on 800 but earn a risk free div on 200. Not bad at all. This is free money for them. If you have any other questions about this let me know. This is pretty common place on the floor. And what you should learn about this is always always always exercise your long calls at ex-div.

nitro · Dec 22, 2003

You couldn't pay _me_ to do this strategy as you described it, especially not on MO.

As a quiz to the original poster, figure out what the synthetic equivalent of being long stock short a call is - it might wave a red flag at you.

nitro

Quote from Maverick74:

Yeah this is a very simple div play. Here is what they are doing. They are buying deep in the money calls because that is similar to buying long stock. They are then shorting an equal amount of in the money calls. What they do is when the stock goes ex-div they exercise their calls the night before thereby being long stock. The next day they have a long stock position and short call position or a buy write. They collect the cash dividend from the long stock. Now two things will happen. What they are hoping for is that a lot of people forget to exercise their calls ex-div, believe it or not they do, if they do, the calls will drop by the amt of the dividend and they will essentially earn the div risk free. Not a bad play.

If they do get exercised, they are simply flat, they will have long stock and collect the dividend but then they will owe it back on the short calls so they will break even on those. See here is the idea. Lets say a trader does 1000 of these. He might breakeven on 800 but earn a risk free div on 200. Not bad at all. This is free money for them. If you have any other questions about this let me know. This is pretty common place on the floor. And what you should learn about this is always always always exercise your long calls at ex-div.

GATrader · Dec 22, 2003

Nitro your point about the synthetics is well taken and I hope these guys doing there are really doing the spreads on really deep ITM

Maverick74 · Dec 22, 2003

Quote from GATrader:

Nitro your point about the synthetics is well taken and I hope these guys doing there are really doing the spreads on really deep ITM

Yeah as long as the delta is close to 100 this is risk free guys, do the math.

xtraderx · Dec 22, 2003

why bother buying the ditm calls and excercise, versus just buying the long stock?

the call price "should" be reduced by the amount of the div at ex-div, similar to how a specialist opens a listed stock ex-div? ive followed a lot of these and it doesnt seem to be teh case, simialr to how its not always the case on the listed stock.

how do the floor guys typically close this position when they dont get assigned, do they just sell teh long stock at the next days open?

thanks

Maverick74 · Dec 22, 2003

Quote from Maverick74:

Yeah as long as the delta is close to 100 this is risk free guys, do the math.

I will add that the way most guys on the floor do this is by buying DITM calls and just shorting stock. Not as messy. But the reason they are shorting the ITM calls is that they are trying to catch some traders sleeping. Most people today are pretty aware of this and evn their broker will remind them but you never know.

Maverick74 · Dec 22, 2003

Quote from xtraderx:

why bother buying the ditm calls and exercise, versus just buying the long stock?

the call price "should" be reduced by the amount of the div at ex-div, similar to how a specialist opens a listed stock ex-div? ive followed a lot of these and it doesn't seem to be teh case, similar to how its not always the case on the listed stock.

how do the floor guys typically close this position when they don't get assigned, do they just sell teh long stock at the next days open?

thanks

Because they earn the spread on the DITM calls thats why. Those spreads are really sweet. Nice and wide. They don't earn the spread by buying stock. If they don't get exercised they will hold their long stock till expiration and have the short calls exercised at expiration which will sell their long stock.

BTW, this is not a good play for guys off the floor because you are paying the spread and they are earning the spread. I know that is obvious to most on here but it doesn't hurt to mention it again.

xtraderx · Dec 22, 2003

Quote from nitro:

You couldn't pay _me_ to do this strategy as you described it, especially not on MO.

As a quiz to the original poster, figure out what the synthetic equivalent of being long stock short a call is - it might wave a red flag at you.

nitro

the synthetic is being short a naked put, right? my understanding of the strategy is very little to no risk, but also a smaller chance of making $$

Maverick74 · Dec 22, 2003

Quote from xtraderx:

the synthetic is being short a naked put, right? my understanding of the strategy is very little to no risk, but also a smaller chance of making $$

Yes it is but since they are short DITM calls unless the stock gaps down huge which I guess it could they are essentially flat stock. If you are short a DITM call its like being short stock. So they are long stock against short stock so thereby not having much risk. The risk they do have is if the stock gaps down 20 dollars and no they longer have a DITM call but rather an OTM call which will not hedge their long stock. Do you follow? The idea here is not to hit a homerun, it's just to capture the dividend. You see that right?