Last dance for options trading strategy around dividends

By Saqib Iqbal Ahmed

NEW YORK (Reuters) - Options dealers looking to snag the coming dividend payment on Apple Inc's (AAPL.O) shares sent the iPhone maker's call volume to a record on Wednesday, but new options market rules mean this may be their last chance for such a strategy.

Large market makers have long used a dividend-linked options trading strategy to make easy money by taking advantage of a hole in the Options Clearing Corporation's rules on clearing trades. New rules set to take effect later this month will close that loophole.

Investors who own call options that are in the money - when the option's strike price is below the price of the shares - can turn those options into shares just before the quarterly ex-dividend date for dividend-paying names. The ex-dividend date is the day on which an investor must own shares in order to collect that quarter's dividend.

Many investors don't do this, however, for various reasons. That's where dealers step in - by buying and selling a large number of call options of the same stock at the same strike price on the day prior to the stock’s ex-dividend date.

Because many retail traders don't elect to buy the underlying stock, the dealers end up in a position to collect dividends on shares they don't intend to hold for long.

"They basically end up making free money," Adam Perlaky, chief strategist at New York-based broker New Albion Partners LLC, said. "It’s clearly a gaming of the system."

The prevalence of this activity is exemplified by recent Apple trading volumes. With the company's ex-dividend date on Thursday, on Wednesday more than 4.6 million Apple call options traded, a one-day record.

Between August 2012 and now, four of the six most active days for Apple call volume have been on the day before the ex-dividend date, according to Trade Alert data.

At the end of the day when the OCC clears trades, owners of the Apple call options could exercise their right to buy shares. Traders who sold Apple call options may be assigned, or be forced to sell the stock at the strike price.

So what's changing? The order in which trades are cleared, which made this trade profitable - and risk-free.

Under the current practice, the OCC first clears those trades in which the call owner gets to exercise his right to buy Apple shares. That's when a large market maker would exercise all its long call options and receive shares.

The OCC then clears trades in which Apple call options have been sold. Those same market makers, who hold massive "short" call positions, sell shares just acquired to settle those positions as well.

Technically these actions should cancel each other out, leaving the market maker with no shares. But in practice, some investors don't convert the calls into shares.

Large market makers count on retail investors to not exercise those options. That leaves them with a small percentage of shares, and as shareholders of record they can collect those dividends while incurring a minimal, and predictable, cost of buying the stock.

The unexercised calls may account for about 5 to 10 percent of total outstanding calls, but sometimes is as high as 25 to 30 percent, Trade Alert President Henry Schwartz said.

Under new U.S. Securities and Exchange Commission rules, the order in which the OCC clears trades for market makers is reversed, rendering the strategy impractical.

The rule change follows Securities Industry and Financial Markets Association’s December 2012 request to the OCC to review dividend plays as they can open clearing members to massive losses in the event of an operational error.

SIFMA had cited media reports from September that year that said Bank of America Merrill Lynch had lost $10 million due to an operational error in processing dividend trades.

The OCC will now first clear those transactions in which traders sold call options, and must sell shares to settle these positions. Following this, the OCC will clear trades in which traders had bought calls.

Clearing the calls sold first forces market makers to buy the shares at some point earlier in the day. This adds a level of cost uncertainty in holding shares that market-makers in options would not want to deal with, strategists said.

"The rule plugs a hole in the system and just makes everything a little bit more transparent," said J.J. Kinahan, chief market strategist at retail brokerage TD Ameritrade Holding Corp.

HIT TO TRADING VOLUMES

The greater transparency will come at the cost of a small dip in overall options volume.

About 3.5 percent of the total equities options this year was tied to this strategy, said Schwartz. Since the strategy is implemented largely at floor-based exchanges such as the Nasdaq-owned PHLX options exchange, the rule's impact on volumes may be more pronounced there, analysts said.

Of the record 4.6 million Apple calls traded on Wednesday, nearly 90 percent was on the PHLX exchange, according to Trade Alert data. That exchange saw nearly 37 percent of overall equity index volumes for all stocks on Wednesday; for 2014, it sees 14 percent of options trading volume.

A spokesperson for the Nasdaq-owned PHLX options exchange said the exchange did not expect a large impact as a result of the changes.

Others said the additional clarity is a benefit to retail traders.

"At a time when exchanges are trying to bring customers back into the market and tell them that they should have confidence in the exchanges, cleaning up this type of trade is something that will benefit everybody," said Gary Katz, who runs the International Securities Exchange and is a longtime critic of this type of trading.

(Reporting by Saqib Iqbal Ahmed; Editing by Leslie Adler)