Minyan Mailbag: Ex-Dividend Trading
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.
Todd mentioned on the buzz that General Mills (GIS) goes ex-dividend today and that could be the cause for the pop in volume of calls that Prof. Erlanger noted with, "no news of note." Could you walk through the how/why of this type of dividend/option trade?
A loyal Minyan
Call option volume can go up dramatically the day before a stock goes ex-dividend.
Shareholders of record on the record date, which is three days after the ex-date (the date the stock trades without the dividend) receive the dividend. This three day period allows owners of call options to exercise the call option the day before the ex-date and receive the dividend.
Call volume will pick up dramatically as option traders execute an almost risk-less trade in order to make free money if someone makes a mistake. Here is how it works.
In the case of GIS which pays a $0.31 dividend and goes ex-dividend the next day, an option trader (let's call her Sheryl) will buy (or try to) a huge amount of the April 40-45 call spreads (buy the 40 call and sell the 45 call) with the stock at $48.25. She then at the end of the day exercises her long April 40 calls into stocks. This leaves her long stock and short the 45 call, which is over 3 points in the money. This is not risk-less for the stock can fall over three points by expiration, but the probability is very small.
What should happen for the person who is long the 45 call is that call should be exercised as well, simply because the position has a 1 delta: that person is short stock and long the 45 call one up. This position is essentially the same as being long a 45 put and since that put is basically worthless, it makes no sense not to exercise the 45 call and pay the dividend. If this person does the right thing (and usually does 95% of the time) Sheryl will be left with no position: she exercised her 40 call and received stock, but her 45 call was also exercised and she had to deliver that stock. In this case she obviously receives no dividend and makes no money.
But if a mistake is made (which sometimes happens) and the person who is long the 45 call does not exercise, Sheryl is left long stock and short the 45 call and receives the dividend. She made $0.31 for free as long as the stock does not fall below the 45 strike by April expiration.
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