Q&A
Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
MECHANICS OF A DIVIDEND PLAY
In early August, Intel (Intc) saw huge contract volume in a handful of deep in-the-money calls. The largest activity occurred in the August 16 and 17 calls with more than 200,000 contracts trading on each strike. The heavy trading happened in front of shares going ex-dividend. With the value of the August 16/17 vertical being maxed out — that is, trading at $1.00 — can you tell me what was going on that day?
What you saw were traders attempting to capture the dividend. By buying and/or selling a deep vertical and exercising his long contract, the trader could be left holding a buy-write if the short contract remains unassigned in front of the ex-date. If all goes according to plan and the inventory of unassigned short contracts is large enough, a quick windfall of overnight profits should greet the trader the next morning as the shares go ex-dividend.
Under this scenario of being long stock and short a deep call, the trader is able to collect the dividend on his or her shares. That’s good news. But the trader loses an equal amount of value in the stock as it goes ex by the amount of the dividend. The potentially great news is the overall position profits by the short call it still holds. The short call contract doesn’t pay out the dividend, but it does decrease by the same amount as the stock.
In Intc’s case, traders were going after a quarterly dividend of $0.16 per share. That may not sound like much, but say you walked away unassigned on 100 short call contracts. That’s $1,600 in potential profit for your vertical-turned-buy-write. It adds up.
I emphasized “potentially” because walking away with the buy-write isn’t easy. In order for the strategy to work, a large pool of open interest in the calls needs to exist. With the Option Clearing Corp.’s random assignment process, the trader wants to have short contracts on a strike where there’s a chance of other, less-informed investors forgetting or simply deciding not to exercise their long contracts.
Further, large open interest in itself isn’t enough to warrant trying to capture the dividend. It’s also imperative the put on the same strike as the short contract has a value less than the price of the dividend being paid. There’s no sense in establishing a buy-write for the dividend if the actual put can be sold to open for more money. Remember, the two strategies from a risk standpoint are virtually the same.
Back to Intc and the heavily traded August 16 and 17 calls. Those strikes made ideal candidates for attempting to capture the dividend, as both the August 17 and 16 puts were worth less than $0.05 versus the dividend of $0.14. By getting away with the dividend, a trader is selling the put or buy-writing above the going market price by $0.09.
In theory, the next day that trader can simply buy in the real August 16 or 17 put for $0.05 or less and lock in the difference. And in this instance, that potential was available to one or more traders. Open interest of 17,000 in the 17 call and 11,350 in the 16 call still found net open interest of more than 4,000 contracts. That represents unassigned opportunity of about $56,000 ($14 x 4000), with the risk of having a short synthetic put in inventory.
Note that commissions do play a very real role in making dividend plays viable. Despite the advantageous rate schedules that many off-floor traders now enjoy, capturing the dividend is still mostly a prohibitive game when nickels and dimes are the prize, like with Intc. And for the heftier dividend plays? The payout would certainly be greater, but the potential of walking away with any short contracts is much less likely.
STOCK PIN RISK?
Can large open interest influence a stock’s actions near or at expiration?
Large existing open interest leading into expiration can influence a stock by acting as a magnet, at least temporarily. Affecting shares in this capacity is the net gamma scalping actions of those holding long premium on the strike.
In the final hours of an option’s life, traders in positions such as the long at-the-money straddle are attempting to scalp stock as aggressively as possible to fend off time decay.
For their part, the short premium sellers are more likely to let those with theta or time decay risk do their bidding by effectively pinning the shares with their actions.
Idealized, large bidding interest is placed below the strike, while short sales are offered above the strike by traders with long curve or long delta-neutral premium positions. Each time a round-turn scalp is completed in the shares, a bit of the time decay from the position is removed.
This process can become self-fulfilling during the final hours leading into expiration. If those traders aren’t taking in enough offsetting profitable stock scalps, standing bids in the shares and overhead offers may be tightened by that same group as they attempt to achieve extra scalps. And that same action may have the effect of pinning the stock at the strike, if no other extraneous catalysts in the shares or market are present.
Contributing analysis by senior Optionetics strategist Chris Tyler.