Shares of International Business Machines (NYSE: IBM, Stock Forum) are up more than $10 since closing below $82 on January 20. The stock has faced bullish tail winds ever since announcing positive earnings after the market closed on that day. Yesterday we saw large call volume in the February options. But don’t be fooled; this is just an option strategy related to the fact that the stock trades ex-dividend tomorrow.
The IBM February 75 calls traded more than 24,000 times versus open interest of 708. The February 80 calls traded over 24,000 versus open interest of 3,100. The February 70 calls traded over 6,000 times versus open interest of 220. With the stock trading around $92.38, down 45 cents with the rest of the market (particularly tech) more than a percent higher on the day, you might say “Was this a bullish investor buying calls that are way in-the-money instead of buying stock?” Or was it a bearish investor selling calls rather than shares??
The answer, in fact, is neither. This trade is neither bullish nor bearish. Instead, it was a trade designed to take advantage of the fact that shares of IBM trade ex-dividend today. Since the shares will trade ex-dividend, the Feb 70, 75, and 80 calls are technically an exercise, because holders of call options do not participate in the dividend. So rather than hold the calls, the owner of the calls should exercise them and get the shares, then get the dividend.
So why all of the volume in the calls? Well, the answer is because if the calls are an exercise then if someone is short the calls and long the stock, they can make a profit on any call that is not exercised. Think of it this way. Any option market maker that is short the IBM Feb 70 calls is long stock against the calls as a hedge.
Say the calls are worth parity right now, so that is 22.38 with the stock at 92.38. If the calls the option market maker shorted are not exercised, then the stock will fall by the dividend amount. So the stock in this case falls by 50 cents (the amount of the dividend) to 91.88. The call the market maker shorted also falls by the amount of the dividend to 21.88. Since the market maker is long the stock (a loser in the fall) and short the call (a winner in the decline), it seems the market maker has no economic gain. But the market maker gets to pocket the dividend of 50 cents!
So based on what we just diagrammed, there is clearly a benefit to being short the calls in case any of the open interest fails to exercise. That is all there is to this trade: market makers trying to get short the calls so they can be a part of the open interest in each of those strikes. So the volume that we saw is market makers buying and selling the calls with one another. All of the trades go on the books as opening. The market makers are smart enough to exercise their calls, and all that is left is anyone who does not exercise. We can see now this morning that the open interest in the 80 calls is just 96, and the 75 and 70 calls have open interest of three contracts each.
Investors should be aware of activity such as this so they do not get fooled into thinking that options activity will give them some clues about the stock activity. When looking at options activity, particularly deep-in-the-money call (DITM) options, investors should at least be aware of this and other arbitrage activity to make sure they have a clear picture of the types of risks people are taking in their stocks.