So AT&T (NYSE: T) trades ex-dividend tomorrow. Owners of this best stock picks will collect 43 cents per share. And as is often the case with decent dividends, that has attracted quite a bit of options interest in dividend capture plays.
And I bet you’re wondering how exactly that works?
Well, if you own calls on a stock, you only collect the dividend if you exercise the calls before the stock trades ex-dividend. Since it ties up capital and/or costs money in the form of interest to carry a stock long as opposed to a call long, there’s rarely reason to exercise until the last possible session. So all the dividend capture action takes place in the trading session immediately preceding the dividend.
Options traders try to capture the dividend by buying and selling in-the-money (ITM) call spreads in the underlying. The traders then exercise the calls they bought and hope to not get assigned the calls they sold. They won’t do it in a vacuum though, they need the calls they sold to have a decent sized pre-existing open interest. Why? Well, that’s the potential quantity of calls that someone will neglect to exercise. It’s either that or hope some trader putting on the dividend play forgets to exercise his calls, an unlikely event considering that he put the spread on knowing he has to immediately exercise what he bought.
Let’s use this AT&T as an example.
With the stock trading near $30, all January ITM strikes are exercises (more on this later). There’s respectable open interest in the calls. For example the T Jan 28 Calls have open interest of 18,605, and the T Jan 29 Calls have open interest of 29,493. So Trader A and Trader B decide to cross 1000 spreads. Trader A buys the T Jan 28-29 Call spread from Trader B 1000 times, paying $1. He then immediately exercises all 1000 of the Jan. 28 calls he bought and hopes he will not get assigned any of the Jan. 29 calls he sold. Likewise Trader B exercises the Jan 29 calls he bought and hopes to not get assigned the Jan 28 calls he shorted.
There’s relatively little cost to the play. The traders’ clearing firms likely will just hit each with a ticket charge and exercise and assignment charges. Let’s say it costs them each $100 overall (very variable). The dividend is 43 cents, so they may only need to get away with three calls to make money on the trade.
But guess what, the odds are stacked against getting away with even that piddling amount. A total of 774,410 T Jan 29 Calls traded today. We can safely assume those will all get exercised. That leaves the original 29,493. If none of those get exercised, that leaves the odds of any one call going unassigned of 29,493/(29,493+774,410), or 3.67%. That’s wildly optimistic though because most of the original open interest will get exercised. Let’s say 90% is a VERY conservative estimate, but let’s use it anyway. That implies that the odds of any one call going unassigned are more like .367%.
So if that happens, Trader A will get away with maybe four calls (assuming some sort of even-allocation system for this example). So he earns $43 x 4, or $172, minus his expenses, right? Not really. He does not have a risk free position, he now owns 400 shares of stock, versus short 4 January 29 calls. That’s the same as shorting 4 January 29 puts, and those puts still have value, 20 cents of value to be exact based on today’s close. So you have to subtract $20 x 4, or $80, and now he has only earned $92, minus his expenses. Or virtually zero.
Long story short, it’s an awful lot of trouble for very little payout. Here are the numbers on some calls heading into the dividend.
January 26 calls: 409,290 trade, open interest of 17,199, put offer of .06
January 27 calls: 342,333 trade, open interest of 14,371, put offer of .07
January 28 calls: 557,910 trade, open interest of 18,605, put offer of .09
January 29 calls: 774,410 trade, open interest of 29,493, put offer of .20
We will see tomorrow how many calls went unassigned and gauge how much money the world actually earned here.
Follow Adam Warner on Twitter @agwarner.
