Sep 24, 2012

BAC Dividend Trade

BofA Unit Said to Lose Millions on Options Error

WSJ reported on Friday that Bank of America Merrill Lynch lost about $10M on SPY dividend trade. I cannot comment on veracity of the story but explanation provided in the article is incorrect in their description of the dividend trade.

The article writes "Usually shares move lower after this date, so call options that give the holder the right to buy the shares also decline in value. Market makers familiar with the process may look to profit from the scenario by selling borrowed call options with the intention of buying them back later, when the contracts are cheaper." , and later "Critics of the strategy charge that it takes advantage of investors that haven't exercised their call options before the ex-dividend date, and don't have the resources to transact big options plays."

That is not quite how the dividend trade works ...
First, let's start with options pricing - dividend is an expected and deterministic stock move, and it is completely priced into the option price. Not only theory of pricing options on dividend paying stock is known and well developed, but also every professional options trader knows dividends and prices options accordingly. If they were not - it would create an arbitrage opportunity, and market-makers are smart enough to prevent them.

Second, while short selling stocks works as selling borrowed shares and buying them back, an opening trade in options creates a long position for a buyer, and a short position for a seller. There is no transfer of security like it is with stocks.

Third, dividend trade works not by just selling an option that is expected to drop in price after dividend, but rather as quoted above - by hoping that holders of long options (which market maker is short) will not optimally exercise them. Market makers usually create Δ-neutral spreads in deep call options (edit: or even on the same strike by trading back and forth - the position is not zeroed out for clearing purposes until it settles at t+1), and hope that short leg will not get exercised. In case of correct exercise market maker breaks even;  if option is not exercised the market maker gains dividend without stock risk. Some exchanges - ISE - are particularly against the strategy, because it creates significant risks if the underlying makes a sharp fall, and options spread suddenly gains gamma. Other exchanges - PHLX - are welcoming the practice; from what I know dividend trade accounts for most of the volume on that exchange.

It is true that the strategy takes advantage of investors who don't exercise their options - which is true of most trading - being smarter than the other guy. The other piece of criticism - about not having resources - that is also true - dividend trade is a low-margin activity, and only traders with low costs can take advantage of them.

P.S. ISE paper with very clear explanation of dividend strategy.

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