Will this strategy work?

Discussion in 'Options' started by DiagonalSpread, Jan 26, 2007.

  1. I'm a bit green with option stategies but I can't see a way to lose with this. Day before a stock goes ex-div do a buy/write with an in the money call then reverse the position after you capture the dividend. Will it work?
  2. No, because the holder of an ITM call will exercise the option, so that he will capture the div.
  3. Not only will this not work as profitaker already pointed out, but your long stock (if it hadn't been called away) might drop further than the amount of the dividend, resulting in more loss (see discussions on covered calls aka synthetic naked puts).
    daddy's boy
  4. spindr0


    There are no free lunches.
    If it looks too good to be true, it is!
  5. I've thought about this many times over, but why does the holder of the ITM call exercise instead of buying stock outright?

    In regards to daddy's post, in the extreme cases of this that I have seen, puts covering downside losses were inexpensive.

    Take a case that I saw not to long ago (numbers are not going to be exact because i'm just pulling this from memory)

    VZ is at like 36.20 and is about to go ex div in a couple of days. Bid on the $35 call is 1.20, ask on the $35 put is $ .10 . You then do the following :

    Buy 100 VZ @ 36.20
    Sell VZ $35 call for $1.20
    Buy VZ $35 put for .10
    Capture div of $.40

    So assuming you don't get called away, you get $.30/share, assuming you pay no fees.

    I understand there is no free lunch, but if someone could provide any info as to why it is advantageous of the buyer of the $35 call to exercise rather than just go long stock, it would be much appreciated.
  6. MTE


    Whether to exercise the call to capture the dividend or not is a simple mathematical issue. When you exercise a call you get long stock, to replicate the limited risk characteristic of a long call you need to buy a put with the same strike price. You pay cost of carry on the long stock and a premium for the put, so if the cost of carry+long put is less than the amount of the dividend then you would exercise the call because in doing that you'd capture that small difference.

    Using your example above, let's assume that there are 30 days to expiry, and the stock is going ex-dividend tomorrow (NOT in a few days, as you'd always wait for the last day before exercising). So, the cost of the put is 0.10. The cost of carry on the long stock is 35*0.0525*30/365=0.15. So, in total, the cost is 0.25 (0.1+0.15), which is less than the 0.40 dividend, so a call holder will exercise the call to capture the dividend, because he/she will get that extra 0.15. It would be stupid not to exercise the call early, unless of course the commissions are high enough to eat up all of that 0.15 difference.
  7. clarify please:
    on the above scenario, sold a 35 call for 1.20 with the market at
    36.2, going ex. The purchaser of the call bought the call at parity,
    so when he exercises he is effectively paying the market price of
    36.20, so why not just buy in the open market, at 36.2?

    the above scenario is long a synthetic call ( long stock + long put)
    against a sale of the call at the same strike for a net loss of .1, offsetted by the .3 dividend, net =.2, providing no exercise.

    so again, why exercise, just buy in the open market 36.2?
  8. The holder of a call doesn't take into account his purchase price when he exercises to capture the dividend.

    Whether he paid $1.20, $4.20 or 40 cents for that call, his decision is the same. His only two options are "exercise" or "do not exercise", and one will be more profitable than the other.

    If you can open a conversion and make a sure 30 cents "assuming no assignment", count on getting assigned. You will never see that dividend.
  9. The ITM call will likely drop in value when the stock goes ex-div. How much it drops depends on a lot of factors (how DITM, etc). In most cases, if you hold a significantly ITM call you lose money upon ex-div.

    OTOH, If you exercise the call prior to ex-div, upon ex-div the stock will also drop in value but the stock holder is made whole by receiving the dividend. Hence no-loss.

    So you can see from the above that the short call in your conversion would likely be assigned forcing you to pay the dividend.

  10. MTE


    It's not about the price you paid for the call, it's about which alternative is cheaper going forward.

    That is, you have two alternatives, not exercising the call and forgoing the dividend or exercising the call, buying a put and receiving the dividend. You would choose the one with an edge.
    #10     Oct 18, 2007