Dividend Plays
The day before an ex-dividend date in a stock, option volume can be
unusually high. Tens of thousands of contracts sometimes trade in names
that usually have average daily volumes of only a couple thousand. This
spike in volume often has nothing to do with the market’s opinion on
direction after the dividend. The heavy trading has to do with the
revaluation of the relationship of exercisable options to the underlying
expected to occur on the ex-dividend date.
Traders that are long ITM calls and short ITM calls at another strike just
before an ex-dividend date have a potential liability and a potential benefit.
The potential liability is that they can forget to exercise. This is a liability
over which the traders have complete control. The potential benefit is that
some of the short calls may not get assigned. If traders on the other side of
the short calls (the longs) forget to exercise, the traders that are short the
call make out by not having to pay the dividend on short stock.
Professionals and big retail traders who have very low transaction costs
will sometimes trade ITM call spreads during the afternoon before an ex-
dividend date. This consists of buying one call and selling another call with
a different strike price. Both calls in the dividend-play strategy are ITM and
have corresponding puts with little or no value (to be sure, the put value is
less than the dividend minus the interest). The traders trade the spreads,
fairly indifferent as to whether they buy or sell the spreads, in hope of
skating—or not getting assigned—on some of their short calls. The more
they don’t get assigned the better.
This usually occurs in options that have high open interest, meaning there
are a lot of outstanding contracts already. The more contracts in existence,
the better the possibility of someone forgetting to exercise. The greatest
volume also tends to occur in the front month.