Playing Dividend Stocks With Options

Includes: BX, DIA, KO, MO, MRK, NYX, QQQ, SPY
by: Finance Banter

With recent action being confined to a very narrow trading range, option traders have turned to playing the dividend game. Of the 10 most active listed options on Wednesday, eight were related to stocks going ex-dividend today. They included, Philip Morris , I mean Altria (NYSE:MO), Blackstone (NYSE:BX), Coke (NYSE:KO), Merk (NYSE:MRK) and the Nyse-EuroNext (NYSE:NYX). All saw option volume of at least 25x the daily average yesterday with MO topping the tape at 1.7 million contracts.

The process of trying to capture the dividend payment works something like this. The day before a stock goes ex-dividend a trader will sell in-the-money calls short against either long stock to establish a basically neutral position. The trader is hoping that the short calls will not be assigned (forced to sell out the long position) and will then be in a position to collect both the dividend and take part in the accompanying decline in the share which will lower the value of those calls sold short. Today, shares of MO are down 17c to $20.30, while those $19 calls are off 50c to $1.30. Given the 35c dividend, which more than makes up for the decline in share price, this would be a double winner.

Is this strategy an overlooked profit center? No. The numbers over the past five years show that only 0.09% of ITM options go unassigned following an ex-div date. If you take the past three years when auto-exercise of anything that is a penny ITM it drops to 0.04%. For example, in MO 375,000 of the $19 calls traded yesterday, the open interest today is just 2,175 contracts. That is a 0.0058 conversion rate. And the calls are only $1 ITM and still have a full week until expiration.

Given the associated costs of commissions and carrying the long stock this would be a losing proposition for anyone but the largest institutions that can essentially trade for free. And even for them, this seems more an exercise in keeping their fingers busy than generating real returns.

Disclosure: None