Dividend Arbitrage - Market Analysis for Sep 14th, 2017

SPY goes ex-div tomorrow and this is a good moment to talk about the effects of dividends on options and the games that very big players play on ex-div days to make a quick buck almost risk free.

Option prices are heavily dependent on several parameters including interest rates and dividends. Those factors are usually very small and change very slowly to have a noticeable effect on prices for many options. However there is a massive effect on prices when the underlying pays dividends in a discrete manner (4 times a year for instance). That is the case with SPY ETF that pays the dividend to shareholders quarterly, and tomorrow is one of those days. In this case option prices are affected right before and after the event. The effect is simple, Puts remain overpriced until ex-div, and then collapse in price, calls are also affected due to put-call parity restrictions, however on options with American style expirations the disconnect can grow rather large (like SPY options too).

Another effect of American style options with ex-div dates (like SPY) is that huge players will try to game the whole process. This arb trade requires collusion and is one of the reasons why tomorrow you will see a massive (mind blowing) increase in option trading volume for any underlying that will go ex-div.

The game is simple, you pick a partner that has huge amounts of capital like you, and then divided this trade in two components:

1. One side shorts a huge number of ITM calls before ex-div.

2. The other side buys exactly the same huge number of calls before ex-div (same strike).

As you can see so far the trade is risk free in the aggregate so far.

The second part of the trade:

1. On ex-div date (tomorrow). The side that is long the call will exercise each and all of its call options, gaining a huge amount of shares that will pay dividend.

And that is it, the profit of the trade resides in the way that the OCC deals with option assignments. To make the process flow easier the OCC uses a lottery system to assign the exercised options. It takes the total amount of exercisable options and randomly assigns them to any one that was short.

The trick is that most retail traders with ITM calls will never exercise them ! given a tremendous edge to the players here. Because the total amount of exercised options is lower than the amount that was short, there are good odds that the side that was short will get to keep a good chunk of the short calls intact and that will be the source of profit for this trade: The two players managed to extract dividends without risk here.

The big takeaway from this write up is this:

1. If you have short ITM calls in some place (as part of a more complex trade for instance). They will be assigned tomorrow and your position will be broken. You better have the cash/shares to answer for it. So close ANY positions that have short ITM calls on them today.

2. If you are long calls in SPY (or any other ex-div underlying for  tomorrow) exercise them tomorrow! and get the dividend not doing that is losing lots of money as you lose on the dividend and also because calls will come down in price tomorrow too.

If you don't have enough cash for any of the two, it is better to close positions today and reopen them tomorrow.