When Will Your Stock Be Called Away?

On Tuesday, 10/27/2009, I bought BWP near 26, Boardwalk Pipeline Partners, and sold the Nov 25 calls against it. The ex dividend date was 10/29/2009, Thursday. BWP will pay out $0.495 per share.

Wednesday, the owner of the calls exercised and called away my stock so that he will be owner of record and receive the dividend. The Nov 25 put closed at 0.35 bid 0.5 offered, so it makes sense that the stock was called. What does the put have to do with it?

Conversion

An arbitrageur would look at the conversion to decide whether to do this trade. In the conversion, you own the stock at 26 and sold the Nov 25 call at 1 for a net outlay of 25.

To make the position risk free, you could buy the Nov 25 put.

You will receive 0.5 in a few days from the dividend and it will cost 25 *2% * (number of days to Nov expiration) to carry the position.

So how much would you be willing to spend on the put to make this worthwhile?

At expiration, if the stock stays above 25, the call will be exercised and your account receives a credit of 25. So that is a scratch.

So to do this profitably, the put has cost less than the dividend received minus the interest cost to finance the buy-write.

So that is the condition: d – i > p.

Here is another way to look at it:

Market Maker’s Trade

Here is Stan Freifeld’s derivation for those of you, like me, that feel deriving helps make the connections to understanding. The derivation is based on what market makers might do to get the dividend since their costs are so low. They might buy deep in the money calls and sell the next call up for $5 if that is how far apart they are. Then they exercise the call on the cum date (day before ex-dividend date). Now they have long stock and the short calls that they started with. Of course, the owners of the short calls will exercise too. If they are left with five or ten percent of the position they started with, they have made money if the dividend is large enough.

So we are starting out C1 – C2 > 0 in order to have a profitable position.

We exercise C1 so we have S + d -i -C2 > 0. That is, we have stock, S, the dividend, d, and we have to pay the interest, i, for financing the stock.

S – C2 = -P2 since a buy-write is equivalent to a short put. Put that in our equation, d – i -P2 > 0. Add P2 to both sides and we have our condition for exercise:

d – i > P2

For BWP d = 0.495 i is negligible and P2 was 0.35 So the condition was satisfied.