International Securities Exchange Whitepaper on. Dividend Trade Strategies in the U.S. Options Industry

Transcription

1 International Securities Exchange Whitepaper on Dividend Trade Strategies in the U.S. Options Industry March 2010

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3 Dividend Trade Strategies in the U.S. Options Industry Key Terms Assignment Notification by The Options Clearing Corporation (OCC) to a clearing member that an owner of an option has exercised his rights. For equity and index options, assignments are made on a random basis. Call Option An option contract that gives the owner the right to buy the underlying security at a specified price (its strike price) for a certain, fixed period of time (until its expiration). The investor who sells a call option is obligated to deliver the stock if the call option is exercised. Deep-in-the-money A call option is deep in the money if the price of the underlying stock is well above the strike price of the option. Although the U.S. equity options industry reported 3% growth in 2009, what many industry participants and observers do not realize is that this growth is solely attributable to an objectionable trading strategy called a dividend trade. Not only does this strategy distort market share with millions of contracts, but it also takes advantage of the fact that individual options traders who may lack sophistication or resources will fail to exercise their deep-in-the-money call options in order to collect a corporate dividend payment. The purpose of this document is to explain the mechanics of the dividend trade strategy and its impact on the U.S. options market by going through a series of frequently asked questions about the practice that will reveal the true market dynamics taking place behind volume reported. Q: In December 2009, options on Verizon traded an average volume of about 18,000 contracts per day. On January 5, 2010, volume spiked to over 2 million contracts but trading activity returned to much lower levels the next day. What happened? This significant spike in volume, shown in this chart, was the result of the dividend trade strategy that will be explained below. Options Industry Volume in Verizon (Symbol: VZ) 12/18/2009 1/20/2010 January 5, 2010: 2,104,178 Ex-dividend date The ex-dividend date is the first date when buying a stock does not entitle the new buyer to the declared dividend. To collect the dividend payment, the stock must be owned prior to that date. Average Daily Volume (ADV) in VZ 12/18/2009 1/4/2010: 18,269 Average Daily Volume (ADV) in VZ 1/6/2010 1/20/2010: 36,979 Source: OCC 2

4 Q: What is the dividend trade strategy? Key Terms Exercise To invoke the rights granted to the owner of an option contract. In the case of a call, the option owner buys the underlying stock at the strike price. Long a call option The position of the purchaser (owner) of a call option. Someone who is long a call option has the right to buy stock at the strike price at or before the expiration date. Long stock position A position in which an investor has purchased and owns stock. Open Interest The total number of outstanding option contracts on a given series or for a given underlying stock. Short a call option The position of an option writer (seller) which represents an obligation to meet the terms of the option if it is exercised by its owner. Someone who is short a call option is obligated to deliver stock if the call option is exercised. Dividend trade strategies are transacted by market makers who are trying 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 1. 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. For example, Market Maker A will sell 100,000 deep-in-themoney call options to Market Maker B. Then they will reverse the transaction and Market Maker B will sell 100,000 of the same call options back to Market Maker A. They will do these trades multiple times to inflate the open interest in the products. At the end of the trading day, they each end up long and short the same positions 2. The market makers then exercise all of their long options positions, resulting in a long stock position. In most cases, their corresponding short options positions will be assigned and the market maker will immediately be required to deliver most of their long stock. This is the key to the strategy. For every options position that remains short, the market maker does not have to deliver stock and is able to keep the dividend payment for the stock that they are long. Q: How can the market makers engaging in dividend spread strategies be certain they will remain short on some of their positions? This is where the most critical factor for the dividend trade strategy comes into play. The strategy is based on the principle that some investors will leave their call options unexercised on the day prior to the ex-dividend date. The process that The Options Clearing Corporation (OCC) uses to settle transactions when options are exercised is random 3, so if call options remain unexercised, there is a corresponding likelihood that investors who are short the calls will not be obligated to deliver the stock. If the market makers can remain short on even just a small number of options positions after the settlement process, they will be able to collect the dividend payment on the corresponding long stock positions. Because the market maker is left with a long stock position that is fully hedged by his short deep-in-the-money calls, the dividend trade strategy has little risk in a low volatility environment. 1 In order for an investor to collect the dividend payment, they must own the stock on the day prior to the ex-dividend date, which is often 1-2 weeks before the dividend is actually paid. For an investor to capture a corporate dividend using an options strategy, options models dictate that deep-in-the-money call options should be exercised on the last trading day before the ex-dividend date of the stock. This way, the investor will own the underlying security in time to collect the dividend payment. There are no automatic exercise rules in place for the day prior to ex-dividend dates. 2 The Options Clearing Corporation (OCC) only permits market makers to remain both long and short the same position at the end of a trading day. Other market participants may not do so. 3 This process is called assignment. 3

5 Q: How does it work? Here is a simplified example 4 : The Scenario (on the day prior to the ex-dividend date) Stock XYZ is trading at $50 and will pay a dividend of $0.10 per share. Dividend trade strategies are transacted in deep-in-themoney call options, so in this simplified example, we will assume that the market makers have agreed to use the dividend trade strategy in the $40 calls for stock XYZ. Open interest in the $40 calls (at the beginning of the trading day) is 10,000 contracts. The Dividend Trade Strategy Transactions Market Makers A and B trade the $40 calls back and forth with each other. At the end of the day, they end up with the following positions in the $40 calls: Long positions 500,000 options contracts Market Marker A Short Positions 500,000 options contracts Long positions 500,000 options contracts Market Marker B Short Positions 500,000 options contracts 4 This step-by-step example is for illustrative purposes. 4

6 The Exercise Process In this example, say 90% of market participants in the original open interest pool exercise their call options. Because open interest was originally 10,000 contracts, this means that 1,000 contracts remain unexercised. Market Makers A and B exercise all of their long options positions, meaning they are now long the stock. The Assignment Process 1,009,000 call options have been exercised out of a total of 1,010,000 that were outstanding. OCC now randomly selects investors who hold short positions to deliver the stock for each call option that has been exercised. An investor who is short the position has a 99.9% chance of being assigned to deliver the stock (1,009,000 call options exercised/1,010,000 open short positions). That same investor also has a 0.1% chance of remaining short (1,000 unexercised call options/1,010,000 open short positions). 5

7 The Dust Settles Market Maker A has exercised 500,000 call options, but must turn around and deliver against 99.9% of his corresponding short calls (499,500 contracts). In the end, Market Maker A retains a balance of 500 short call options. He holds stock for 500 of the long call options he exercised and ends up with 50,000 shares of Stock XYZ (1 option contract = 100 underlying shares). He collects a dividend of $0.10 on each of these shares, or $5,000 total.* Market Maker B has exercised 500,000 call options, but must turn around and deliver against 99.9% of his corresponding short calls (499,600 contracts). In the end, Market Maker B retains a balance of 400 short call options. He holds stock for 400 of the long call options he exercised and ends up with 40,000 shares of Stock XYZ. He collects a dividend of $0.10 on each of these shares, or $4,000 total.* Both market makers have collected the dividend payments associated with those shares, and both remain fully hedged with short deep-in-the-money calls. This means they can trade out of the hedged position (or wait until expiration if it is near) after they collect the dividend. *Note: This example is for illustrative purposes only. The dividend payment is offset by the time premium left in the option, so the full dividend may not be captured. Q: What happens to the market participants who were originally short the call options? The market participants who originally held short call positions are disadvantaged because they have a much lower chance of remaining short if the dividend trade strategy occurs. Often times, these market participants are simply retail or institutional investors who held a buy-write position 5 and wanted the dividend payment themselves. Assume Individual Investor A is long 1,000 shares of Stock XYZ and short 10 in-the-money $40 calls in Stock XYZ. In the original open interest pool of 10,000 contracts, Individual Investor A would have had a 10% chance of remaining unassigned and collecting the dividend payment for his long stock positions if unrelated investors failed to exercise 1,000 calls (1,000 unassigned call options out of a total open interest pool of 10,000 contracts). However, because Market Makers A and B engaged in the dividend trade strategy, the open interest pool was inflated by 1,000,000 contracts. Now, Individual Investor A only has a 0.1% chance of remaining unassigned. This means that it is highly likely that he will be assigned on all of his short positions, will have to deliver his long stock, and will not be able to collect the dividend payment. Instead, Market Makers A and B will obtain the dividend payment that Individual Investor A could have collected. 5 A buy-write position is a covered call position in which stock is purchased and an equivalent number of calls is written at the same time. Example: buying 500 shares XYZ stock, and writing 5 XYZ $40 calls. 6

8 Q: Why doesn t everyone who owns a deep-in-the-money call option exercise it? Most professional investors are aware that they should exercise their deep-in-the-money call options to collect a dividend. However, there are many reasons why individual investors may fail to do so. An individual investor may be unaware that a stock is going exdividend, or they may not have the money to buy the stock. The dividend trade strategy is based on the principle that less sophisticated individual investors will fail to exercise their call options. If everyone exercised their call options, this strategy would not work. Consequently, market makers will only use the dividend trade strategy if there is a significant amount of existing open interest. Q: Why didn t dividend trade strategies occur in 2008 to the degree that they did in 2009? A low volatility environment is conducive to this type of trading as it makes this strategy virtually risk free. With low volatility, it is very unlikely that the stock will move through the deep in-the-money strike price where the price of the stock is lower than the strike price. That is, the position remains hedged. With high volatility levels in 2008, this strategy was riskier. However, the use of the strategy returned in 2009 when volatility returned to lower levels. Q: Why do dividend trade strategies only occur in deep-inthe-money calls? The strategy only makes economic sense if the strike price for the option is lower than the trading price of the stock. Q: Don t exchange transaction fees make dividend trade strategies prohibitively expensive? Dividend trade strategies can only occur if exchange fee caps are in place. Without fee caps, the cost to transact the strategy would be far greater than the profit from the dividend payments. ISE has never supported these types of trades through the use of fee caps, and as a result, they do not occur here. Q: Where do these trades occur? Because these trades are pre-arranged, they are primarily transacted on floor-based exchanges. The distortion in market share is clear when looking at the difference in market share distribution when dividend trades are transacted and when they aren t. Take the example of the market share distribution of options on Verizon. The day prior to Verizon s ex-dividend date was January 5, The charts below show market share by exchange for the 10 days before January 5, and on January 5: 7

9 Industry Market Share in VZ 12/18/2009 1/4/2010 ADV: 18,269 Industry Market Share in VZ 1/5/2010 Volume: 2,104,178 Q: What is the benefit to the exchanges where these transactions occur? The only benefit to the exchanges where these trades occur is inflated volume, and as a result, distorted market share. The trades create an optical illusion that gives the exchanges where these trades take place the appearance of liquidity and profitable volume. Q: Isn t all volume equal for the industry regardless of what type of strategy is being used? Dividend trade volume is harmful to the U.S. options industry (see below), and the only benefit is inflated market share when in fact the volume provides little financial benefit to the exchange and is not accessible to other market participants. Q: What impact do dividend trades have on the U.S. options industry? 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. Dividend trade strategies do nothing more than paint the tape, creating the appearance of healthy order flow. For the individual investor who has been trained to associate high trading volume with news in the individual stock, these trades are very misleading. The strategies distort market share in the U.S. options market, negatively impacting order flow providers who make routing decisions based on liquidity. The risk of engaging in dividend trade strategies far outweighs any potential profit for those who participate in these transactions. If any kind of mistake is made in the clearing process, a clearing member could be liable for an excessive amount of money. On the other hand, the dividend payments that are actually collected as a result of these transactions are relatively small. 8

10 Q: How much money can be captured through dividend trades? First, for an exchange, there is very little economic value since fee caps must be in place for these trades to occur. In addition, it is important to note that because market makers are the only industry participants that are permitted to be long and short the same options position overnight, they are the only group that can potentially benefit from these transactions. There is a limited group of market makers who can engage in this strategy, and their potential profit on this strategy is relatively small. Because of this, we believe that the risks of this strategy, which are described above, outweigh any potential profits. Q: How did dividend trades distort market share in 2009? The graphs below illustrate the impact. The first chart shows reported equity options market share by exchange for The next chart shows equity options market share for 2009 with dividend trades excluded from the volume. The difference is notable. 9

11 Q: Should dividend trades be included in industry volume? We do not think they should. Beyond the fact that the dividend trade strategy is based on objectionable principles, it is nothing more than an optical illusion. The liquidity, or appearance of liquidity, is not accessible to any other industry participants, and it does not provide economic value for the exchanges where they are transacted. Volume from the dividend trade strategy accounted for nearly 13% of industry-wide equity options volume in December 2009 alone a total of nearly 35 million contracts. In fact, when the smoke is cleared away and dividend trades are removed from industry growth calculations for 2008 and 2009, the U.S. equity options industry actually shrunk by 0.1% for the full year 2009 compared to Industry ADV in Dividend Trades Industry ADV in Equity Options Q: Can dividend trade activity be tracked accurately? Dividend trades are easy to identify, as the example of the trading activity in options on Verizon on January 5, 2010, illustrated. ISE s calculations are based on a formula that identifies deep-in-themoney call options that are executed in large size on the day prior to the ex-dividend date of a stock. Q: What is the SEC s position on dividend trade strategies? To date, there are no rules in place that prohibit the trades from occurring. 10

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