Investment XYZ

Wednesday, May 10, 2006

Why the Deluge of GM Calls

On May 9, 2006, a GM May 20 Call (which had about 10 days to expiration and was in-the-money), spiked in trading volume to a jaw-dropping 288,000 contracts traded in a single day. The normal trading volume on this option is only a few hundreds to a few thousands, the Open Interest on this strike before this day was 22,215. The turn-over rate of this option on this day was not just much much higher than regular volume, but much higher than open interest.

What was going on? If you asked an option trader, he was sure to snicker: "It's a dividend play."

What? Isn't it because people are very bullish about GM? On that day, GM got an upgrade, and the stock made a huge $2.25 jump, a big jump for GM since it is slowly recovering from a junk-bond state reached in April. Also, stock trading volume was huge. Since there was a huge short interest in GM stock, there was speculation of creating the possibility of a short squeeze. All these seem to be along the same line as the huge volume in this May 20 Call. So wasn't this call buying part of a bullish stock buying orgy? Had it anything to do with a dividend?

The GM ex-dividend (ExDiv) date was the following day, 5/10/06 with a dividend amount of 0.25 (which was cut in half since last quarter). On ExDiv day, the stock should open at a price 0.25 lower than the previous day's closing pricing, before the stock can start its random walk. For stock investors, there is absolutely no arbitrage opportunity (there may be some tax consideration, but that's individual dependent). If you buy the GM on 5/9/06 at a closing price of 25.8, the next morning, your equity is worth 25.55, plus you get 0.25 in cash, no change at all in your total value. Any subsequent change in value results from the random walk of the stock price, thus it has risk. In other words, for stocks, there is no risk-free arbitrage opportunity at all.

Then how about the calls? Are they just like stock, no chance for arbitrage for some risk-free money?

A Call is the "right" to buy stock at a certain price. The GM May 20 Call, which is an American style option, is "a contract for the holder to buy the GM stocks any time before 5pm EST, May 19 2006 at $20/sh". When you hold this contract and do not exercise it, you do not own any stock on the day before the Ex-Dividend date, thus the holder of the Call contract is not entitled to a dividend distribution (the dividend is distributed only to stock holders settled on 2 trading days after the ExDiv date, which is to say, you have to hold or buy stock on the day before the ExDiv date because the stock trade takes 3 trading days to settle). If you buy the Call and exercise the right on 5/9/06, you are entitled to the dividend, thus the net result is exactly the same as buying stock.

What happens if the holder forgets to exercise? On 5/10/06, the Call will open with a drop of $0.25, just like the stock. However, the stock holder will get the $0.25 dividend in return so that there is no change in value, while the call holder does not. Thus he would just lose $0.25 per share overnight, without any risk involved. In his opposite, the option writer who was not assigned will simply pocket the risk free money of $0.25, or $25 per contract. For 300,000 contracts, that $7.5 million potential risk free money in the option seller's hand. However, the actual arbitrage potential is much smaller. Only a small portion, typically 5%, of option holders who belong to the "dumb customer" class, forget to exercise the calls on the day before ExDiv, so there is likely "only" $375,000 riskfree money.

How would the option writers catch this risk free money? All he needs to do is to hedge this call exactly as stock immediately after the call is sold. The next day, if the option is assigned, his stock is called away and he has not gain or loss; if the call is not assigned, he has a net profit of $25 per contract.

Now an interesting question: how can the option writers create such a huge volume? There can't be so many "dumb customers" showing up to buy calls on this day...

Actually all these trades are done with the market makers, who would never forget to exercise the options (it is part of the standard operation in option market making). Then isn't that the trade is totally wasteful, if the long sides are sure to exercise the calls?

The magic lies in the "lottery" system of option assignment in the option clearing house. After an option is traded, the two sides of the trade no longer have any link to each other (thus there is no counterparty risk). All the trades are consolidated and netted out in the clearing firms (and ultimately at Options Clearing Corporation or OCC). When an option is exercised, the clearing house can no longer trace back to the other side of the contract. Thus a lottery system is employed. The short sides are randomly drawn from a pool to be assigned for the exercise orders. Thus as long as there is a percentage of option holders forgetting to exercise, there is a chance for the short side not to be assigned, and that chance is independent of who is your counterparty in the initial trade.

Let's look at an example: supposed the open interest of a call option is 1000, which means there are 1000 contracts on the short side and 1000 on the long side. If one contract holder (on the long side) wants to exercise his 50 contracts, he is holding, here is what will happen in the process: he sends the exercise order to his broker, who will inform OCC -- the organization who take track of exchange traded option open interests, besides many other functions related to option exchanges. How can the OCC picks from the 1000 contracts of short positions and decide who should be assigned? Since it is no longer possible to trace back to who was the counterparties of the 50 contracts to be exercise, a lottery system is certainly a fair way for such situation. OCC will randomly choose 50 from the 1000 contracts short positions, and whoever get picked would be assigned -- which means a short call position becomes a short stock position. In another word, every short holder has 1 in 20 chance being assigned when a 50 contracts exercise order coming into a 1000 contract pool. In such a lottery system, the short option contract holders have no idea when he will be assigned until he is actually being informed. Even at the option expiration, if the option strike is very close to stock price, there is great uncertainty for the short holders whether he will be assigned or not.

Now back to the GM Call option story. Why did the heavy trading occur at this strike (20 Call)? What about GM May 25 Call? For a call option to be exercised before expiration ("early exercise"), the option should 1) be deep in-the-money; 2) have little time value left; 3) have a substantial dividend. Comparing to the May 20 Call, the May 25 Call is near the money and has too much time value embedded. Then what about the dividend that can cause the stock to drop? Is it a bad deal to hold onto a May 25 call that will suffer the drop but is still not worth to be exercised? No, its option price should be still fair: the dividend is already built into the price thus no sudden drop in call price before and at the ExDiv date.

For the May 20 call option trades on May 9, why there is still such risk-free money in the market place? Arbitrage, or risk-free money is what keeps the market fair and consistent. For example, the old fashion cross-market arbitrage fulfills the "social responsibility" of getting everyone a single price at all liquid markets at any moment. The call-exercise arbitrage as in this GM case goes a little deeper than other no-brainer arbitrage situation. In cross-market arbitrage, the opportunity disappears when there are many arbitrageurs piling in on the same trade. While in the call-exercise case, you trade (write) as many such calls as you can -- the opportunity never goes away, but only a small percentage of trades can be profitable. Such arbitrage requires data sophistication as well as a certain percentage of "dumb customers" (who do not know about the exercise to capture the dividend) in the total investor population.

In fact, selling a Call to capture the "leak" in dividend is not a true arbitrage in another sense: there is a potential huge risk involved: selling the deep in-the-money call is the same as selling a way out-of-money put (when the short Call is hedged with stock). In case the calls are not assigned, the call writers can get hit by a sudden large drop in stock price. Such a risk is even more prominent if the call is in the border line of whether it should be exercised or not (namely, the call is not very deep in-the-money).

In any cases, some traders who have the sophistication of data and hedging are willing to take such risk for the dividend opportunity for any stocks that distribute large dividends. Interestingly, this trade only depends on the size of the dividend, not on the stock price (thus it is not necessary to find a high yield name for such trades). Recent examples: C, WFC, GS, PG, and a big one: PD (which had a large special dividend on May 12, 2006).

Are there any lessons to be learned for investors playing options? Yes, just be careful when you hold a deep in the money call option. It may behave just like stock -- most of the time except when it gets close to the ExDiv date. So make sure you check the dividend and ExDiv date, if you are not sure whether you should exercise or not, just sell the option before the ExDiv date.

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