Ex-Dividend Call Option Strategies For Buyers And Sellers

| About: HCP, Inc. (HCP)

Summary

Covered call sellers are not always aware of their options.

Call buyers can take advantage of ex-dividend dates.

Market makers will do their best to snatch dividends from the unwary.

In my first article for Seeking Alpha I wrote about one side of a call option strategy useful on the day before an underlying's ex-dividend date. In this article I illustrate the strategy for both sides of the trade.

Understanding these strategies is important for both buyers and sellers of call options. Studies have shown that small investors leave hundreds of millions of dollars "on the table" by not being alert around ex-dividend dates.

Background

HCP, Inc. (NYSE:HCP) was set to trade ex-dividend on February 4, 2016, with a dividend of $0.575 per share payable February 23. Both buyers and sellers of in the money call options have strategies available to them when this situation occurs.

Sellers' Strategies

  1. Buy to Close
    1. Seller simply wants to retain the underlying and collect the dividend.
  2. Roll-Out
    1. Seller wants to collect the dividend and obtain additional premium income.

Buyers' Strategies

  1. Sell to Close/Buy to Open
    1. Buyer wants to profit from the expected drop in the underlying on the ex dividend date.
  2. Exercise
    1. Buyer wants to own the underlying and collect the dividend.

These strategies play out over the course of the day, but most of the activity tends to be near the close. The table below tracks HCP and its February, March, and April $35 call options through the February 3 trading day.

Notes:

Assignment happens after the close so call buyers who exercise won't show up in the volume numbers.

Early assignment generally occurs only with the front month, but I track all three for this exercise.

As you can see, the February 35 calls were in the "danger zone" immediately with a time value of just 24¢, well under the 57.5 cent dividend.

At 10:45 there has been some volume in the March $35 calls. There is no way to tell which side of the trade these originated on until after the close when we expect see a drop in February open interest.

By 11:45 the March $35 calls were in the zone and the April calls were had only a 17.5 cent cushion.

At 12:45 the March calls slipped out of the zone and the April calls expanded their cushion to 26 cents.

By 1:45 March is back in the zone. The April calls added a penny to their cushion.

At 2:45 February and March are solidly in the zone. April's cushion shrinks to 18 cents. There has been additional volume February and April.

By 3:45 things are pretty much locked in. The April $35 calls will escape exercise (they almost certainly would even if they were in the danger zone) as will March but it looks like February will be assigned for sure.

And it's a wrap! Ten more March contracts changed hands, but that's it. Now we wait while the Options Clearing Corporation does its thing. Exercised options are randomly assigned by OCC.

Thursday Morning!

And here we are with the open interest in the three months.

The 36 contract increase in March and April options may be roll outs or new positions; there's no way to tell (but it does happen to correspond rather neatly to the change in February open interest).

As expected there were no apparent exercises of the March and April contracts.

Note that although there was a net 150 contract drop in open interest there were 19 contracts left. This is not uncommon with relatively thinly traded options such as HCP.

High volume options (many thousands of contracts) are likely to be subject to something called the "Dividend Trade" in which market makers execute pre-arranged trades of huge quantities of options and the corresponding underlying. Because the OCC assigns exercises randomly this strategy can, in effect, sweep up any positions left short by unwary investors.

For additional insight into this situation I suggest Listening to this Vanderbilt University podcast with Professor Bob Whaley. The corresponding academic article can be found here.

Implementing The Strategies - Sellers

Buy To Close

When: Anytime before the ex-dividend date

Why: Use this strategy when it won't wipe out your profit from the original sale of the options. Many covered call sellers will buy back their short position whenever its price is half (or some other percentage) the amount of the original sale.

Roll Out

When: The day before ex-dividend (or at expiration)

Why: When "buy to close" would be a money-losing proposition.

This strategy requires that a suitable more distant contract is available. Unfortunately, that's not always the case, particularly if the stock has run up and the reasonable strikes are deep in the money.

In today's example investors short the March $35 calls could have rolled out to April for a net credit of $0.50 - $0.75 at any time during the trading day.

It is sometimes possible to "buy up" to a more distant but higher strike. Doing so is a matter of personal choice. I'm willing to consider it if the cost of doing so is no more than half the amount of the strike increase and is similar to the premium I got when I sold the calls. In a case like that I'm effectively trading my original profit for additional capital appreciation.

Implementing The Strategies - Buyers

Sell to Close/Buy to Open

When: The day before ex-dividend

Why: This strategy takes advantage of the drop in the option's premium when the underlying trades ex-dividend. In the HCP example above an option owner could have sold his February $35 calls during the day for as much as $1.95 (presumably at a profit). Now that HCP is ex-dividend those same calls have an ask price of $1.40. A quick round trip profit of 55 cents, roughly the equivalent of the dividend the call owner doesn't receive.

Exercise

When: The day before ex-dividend

Why: With the underlying above the strike price, this is the last day to own the stock and receive the upcoming dividend.

Conclusion

There is more than one way to take advantage of equities about to trade ex-dividend. Both option buyers and sellers need to be aware of the strategies they can use to maximize their returns and avoid unnecessary loss of their underlying equities prior to an ex-dividend date.

Disclosure: I am/we are long HCP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.