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Dividends at Play in the Options Markets

August 16, 2006

Dear Fellow Options Trader,

"If ignorance paid dividends, most Americans could make a fortune out of what they don't know about economics." -- Luther H. Hodges

We kicked off this week with a stampede from the bulls on Monday that ran the Dow up 115 points, but that rally was quickly met with equally bearish ferocity that erased those early gains. Then yesterday, the bulls got another shot in the arm in the form of a very benign Producer Price Index (PPI) report, which showed the core PPI in a full-on decline! That set in motion a triple-digit rally in the Dow and a 20/32 jump in the 10-year Treasury bond, which meant the yield for that 10-year note had fallen to 4.91%.

The reason all of this was being viewed so positively by the Street was that it increased the likelihood that the Federal Open Market Committee (FOMC) could extend its current pause rather than resuming the interest rate hikes of the past 25 months.

For the record, just about anything that causes the pauses is a good thing for the markets. Take my word for it.

MAKING PROFITS THROUGH OPTIONS AND DIVIDENDS

Here's a strategy very few of you might have heard about, and probably even fewer still know what it really means. The term "dividend play" is a situation in which market makers and off-floor pros trade in and out of call options the day prior to a dividend being issued.

It can cause novice traders and investors to believe something bullish is brewing in a particular stock, as the ratio of trades happening in the call options will completely eclipse that of the puts. Here is what's going on that causes this massive surge of trading.

In order for a dividend play setup, you need the following:

* A dividend due the next day.
* An in-the-money call option series with large open interest.
* Puts that are offered for a dime or less.

The dividend is the central, but not only, component. It's been my experience that the dividend play will not be attractive unless the dividend is at least 10 cents. Because virtually every equity option can be turned into 100 shares of the underlying security, a 10-cent dividend would result in $10 to the holder of 100 shares of stock.

The in-the-money call with a large open interest is vital to the dividend play, as every call option gives the owner of the call the right, but not the obligation, to buy shares of stock at the strike price of the call.

What I will call your attention to is the phrase "the right, but not the obligation," as this is what creates the opportunity the pros are seeking to exploit. You see, there will be owners of in-the-money calls who will either forget to exercise their calls for the dividend, or those who cannot afford to transform a $2 call option into a $34 stock.

Professional traders will look at each in-the-money call for open interest, which they will view as an opportunity to be exploited if those calls were to remain unexercised into the dividend. But prior to the transformation of calls to stock through the exercise process, the traders understand that the corresponding put must be offered for less than the dividend.

Why's that, Doc? Because the person exercising their in-the-money call must understand that they are trading a very limited-risk call for shares of stock that could be 10, 20, even 50 times the value of their call.

Think about it. A $2 call has an absolute value of $200, as it represents 100 shares of stock. But once exercised, the call can become 100 shares of a $30, $50 or $400 stock! So, essentially you're exchanging the risk of holding $200 worth of calls for $3,000, $5,000 or even $40,000 worth of stock.

And if you're holding stock before the ex-dividend date, then you're eligible to receive any dividends that the stock pays out. So, not only are you entitled to any profits on the actual stock, but as the owner of record, you also get a nice bonus in the form of the dividend.

How does this relate to options? Simple -- if you're holding a call option that's in-the-money, you can sell it for a profit without touching a single share of stock. Or, you can buy shares at the strike price of the option. And if your call is profitable, that means the market value of the stock is higher than the price where you have the right to buy it!

A DIVIDEND PLAY IN ACTION

Yesterday (Tuesday, Aug. 15), our HeatSeeker picked up the unusual buying of calls in International Paper (IP). The sheer size made me take a gander at the potential for a dividend play and, lo and behold, I saw that IP was due to go ex-dividend today (or, trading without dividends) for 25 cents. Again, knowing that each IP call would (at the owner's discretion) be turned into 100 shares of stock, this meant each dividend captured would become a $25 windfall.

Here is a shot of the IP August calls from Aug. 15:



Look closely at the open interest at the August $30 and $32.50 strike prices. There were 6,274 calls open at the $30 strike and another 20,770 open at the $32.50 strike. That means there is the possibility that $156,850 in dividends could be captured at the $30 strike (6,274 x $25 = $156,850). However, there was also another $519,250 on the table at the $32.50 strike (20,770 x $25 = $519,250).

That's why you see traders buying and selling 45,160 of the IP Aug 30 Calls and 120,016 of the IP Aug 32.50 Calls. It's not uncommon to see traders very, very aggressively buying, selling and exercising five, 10, even 20 times the open interest, just to be part of those calls that would otherwise go unexercised.

With these August options expiring on Friday, this dividend play is an immediate-turnaround strategy that allows buyers to obtain calls that give them the right to buy shares for $30 or $32.50, which they had to do in a hurry to earn the dividend. And with IP trading at $35 today, not only did they get the stock at a nice discount, but they also became eligible for the 25-cent dividend on top of that.

So, the next time you see huge volumes of calls changing hands without any news as a likely driver, take a look at the dividend ex-date, the open interest in the in-the-money calls and low-priced puts, and you'll probably see a dividend play being, well, played out!

Good luck trading and remember -- pigs get fat, but hogs get slaughtered, so don't be a hog!


Jon "Dr. J." Najarian
Editor
ChangeWave Options Trader


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In my session "How Private Equity Buyouts are Changing the Takeover Game and How You Can Profit From It," I'll discuss how the U.S. and European merger-and-acquisition business can mean staggering profits if you know how to trade off of this information. I'll let you know exactly what's going on and how you can play this momentum to your advantage.

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I look forward to seeing you in San Francisco!