Interestingly, the trade that BofA apparently lost so much money on Friday is actually designed to take advantage of individual investors, not big market makers. So, the plan seems to have backfired.
Jim Binder of OCC (@jimbinder) sent us a white paper from the International Securities Exchange detailing how the trade is supposed to work.
The strategy is all about capturing the dividend payment from a stock while taking no directional risk in the trade. The way market makers do this is by opening big simultaneous long and short positions with each other via call options, distorting the market in the process.
However, the profitability of the trade ultimately hinges on smaller, individual investors forgetting to exercise their options at the right time. That’s what the big market makers are counting on.
Below is a walk-through of how the trade is executed. Here is the set-up:
Now, take a look at what happens when the two market makers employing a dividend trade options strategy place their trades with each other.
Essentially, trader A opens a long call position with trader B, meaning trader B is short that call. At the same time, trader B opens a long call position with trader A in the exact same stock and of the exact same size.
Because of the way options are cleared at the OCC, the two trades don’t net out against each other, and the two traders find themselves with identical positions:
The key thing to notice in the diagram above is the size of the trades. Before the trades were placed by the market makers, the total “open interest” – or amount of open call option contracts – in this particular stock was 10,000.
Now, when you add the two trades by the market makers totaling 500,000 calls a piece to the open interest pool, the new open interest on the stock is now 1,010,000 – or 101 times bigger than before.
That’s the massive distortion that is created in the options market to execute the trade – what follows is how it makes the big market makers money.
In order for the market makers to capture the dividend payment from holding the stock, they are counting on individual investors from the original open interest pool to forget to exercise their options.
This scenario assumes that 10 per cent of the little guys forget to exercise their calls. In that case, 90 per cent of the holders of the original short positions – before the market makers placed their big trades – is on the hook to pay out dividends to those holding stock:
Meanwhile, after exercising their call options, the market makers take delivery of the actual shares of stock underlying the options contracts, while still holding on to their short positions. Now, they own the shares and are waiting for the dividend payment they receive as holders of the stock.
This next part is where the action happens. The people holding the short call positions in the stock now have to pay the dividend to those holding actual shares of the stock.
Remember, at this point the market makers are holding an equal position in actual shares of stock (which they receive the dividend payments for) and short call options on the same stock (which means they have to pay the dividend to holders of the shares).
The trick is that because not everyone (like the average individual investor) is exercising the call options and thus taking delivery on the stock (which means they miss out on the dividend payment).
Thus, only 99.9 per cent of the short call positions will be required to pay out the dividend – which means the market makers net a profit on dividend payments received on 100 per cent of the stock they are now holding and only have to pay out dividends on 99.9 per cent of their short call positions:
100 per cent less 99.9 per cent may not sound like much of a spread for the big traders to capture, but because they artificially inflated the size of the open interest pool to such a large extent in the first step, they can make a nice chunk of change on the trade.
Here is what the market makers stand to gain once the trade is completed:
Needless to say, the ISE is not thrilled about this trading strategy and has effectively rendered it unprofitable on its own exchange by charging fees to the market makers. In contrast, some other exchanges where the strategy is employed have “fee caps” that allow these trades to be profitable (keeping the big clients happy is good business for the exchange).
If it’s still unclear, here is ISE’s explanation of how the individual investor is getting screwed by this trading strategy:
The market participants who originally held short call positions are disadvantaged because they have a much lower chance of remaining short if the dividend trade strategy occurs. Often times, these market participants are simply retail or institutional investors who held a buy-write position and wanted the dividend payment themselves.
Assume Individual Investor A is long 1,000 shares of Stock XYZ and short 10 in-the-money $40 calls in Stock XYZ. In the original open interest pool of 10,000 contracts, Individual Investor A would have had a 10% chance of remaining unassigned and collecting the dividend payment for his long stock positions if unrelated investors failed to exercise 1,000 calls (1,000 unassigned call options out of a total open interest pool of 10,000 contracts).
However, because Market Makers A and B engaged in the dividend trade strategy, the open interest pool was inflated by 1,000,000 contracts. Now, Individual Investor A only has a 0.1% chance of remaining unassigned. This means that it is highly likely that he will be assigned on all of his short positions, will have to deliver his long stock, and will not be able to collect the dividend payment. Instead, Market Makers A and B will obtain the dividend payment that Individual Investor A could have collected.
What went wrong on Friday, then? It’s still unclear. What is known is that a huge portion of the long call options on SPY – the ETF being gamed in that particular trade – went left unexercised. So it seems like someone somewhere along the line forgot to make sure they followed through on the process described above.
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