Now I know why I didn’t write about this before. This was a dumb trade. There is no time value in the call, it is exactly 1.32 below the stock price.

The reason is that the ex-dividend date was two days later on the 29th. The stock would drop by nearly the dividend paid, fifty seven and a half cents a share, and the call will stay where it is. On that day, CPNO closed at 17.93 from 18.25 the day before. Dropping just 0.32.

A few days later I compounded my error. CPNO was trading at 16.90 and the call was at 0.38. If I closed out the trade, I would have a 1.98 loss on the stock, a 0.94 gain on the call and 0.575 in dividends for a loss of 0.465 plus commissions. CPNO was out of the break even zone of the buy-write.

What I did was to buy the 17.5 call and sell the 15 call for a credit of 1.55. That way I felt protected. When I closed out the trade a few days later, my loss was 0.442 after commissions. Slightly better than closing it out earlier, but not worth the extra few days.

The author claims that there is a run up in price three to four weeks before the ex-dividend date due to traders who want to capture FAV’s 0.46 quarterly dividend. Then a collapse after the ex date.

FAV price

Here is a list of the last few ex-dividend dates:

10/21/2009: price ran up to 13.50 from 12 and a quarter at the beginning of the month.
7/22/2009: FAV ended June around 10 and ran up to 11 and a half.
4/22/2009: FAV ended March at less than 8 and got past 9 by ex date.
12/29/2008: FAV started December at less than 7, and got to 8 and a half.
10/20/2008: FAV ended September around 9, only got to 8.7 before the ex-date. It dipped as low as 6.
7/18/2008: FAV started July around 12 and never got much above that.
4/18/2008: Started the month around 12 and went to 12.20.

Three good moves and one loss and one scratch and one small profit. Not a bad run.

Is This Rational?

It is well known that it is individual investors who buy closed end funds. This buying interest before the ex-dividend date, if we agree that is what we are seeing, is irrational. The net asset value of the fund should be unchanged by the payment of dividends by the stocks that it holds. The price of the fund itself should drop by the dividend amount it pays, modulo tax considerations. So there should be no extra interest in FAV around dividend paying time.

A commenter on the original article mentioned that the same phenomenon can be seen with master limited partnerships like ETP, EPD, BPL, and OKS. It will be interesting to look at this.

Minnesota Mining & Manufacturing

A steady conglomerate paying steady dividends. So 29th October I thought it would pay its dividend around the 19th of November, like last year. So I bought some stock at 75.24 and sold the Nov 75 call for 1.8 giving about 2.4% of downside protection. The beta of MMM is 0.8 so you could say that we have about 3% downside protection on the S&P 500.

There was 0.24 of intrinsic value and the rest, 1.56 time value in the call.

Usually MMM announces the dividend eight to nine days before the ex-dividend date and it hasn’t announced yet.

Today, MMM was trading near 78.75 and the call at 3.9, 3.75 in the money. My return would be 1.41, so I took off the trade. My reasoning was, if the ex-date is before November options expiration, and the stock is called, I would earn another fifteen cents, but I would have to wait about nine days. If MMM dropped enough so that it wouldn’t be called, I would get the 51 cents dividend if the ex-date is before expiration.

Didn’t seem worth waiting for. What do you think? Comment below.

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.

I checked with the exchange to see how many Nov 55 calls there were Thursday, Friday (cum-date) and Monday morning (ex-dividend date). The open interest was 358 for both Thursday and Friday. Monday morning, it was 213. About forty percent of them had been exercised over the weekend.

Yesterday I noticed that Clorox is announcing earnings next week on the 4th of November. Even though Clorox is a placid stock with a beta of .4, meaning that it moves just 40% of the market move as a whole, I don’t want to be exposed to any surprises.

So today I unwound the buy-write and sold CLX at 58.1 and bought back the calls at 3.6 for a combined credit of 54.5, which is where I bought it. So I clipped the dividend, minus transaction costs, in twenty days.

I’m going to try to reduce the time that these positions are held. Stay tuned.

PPH

Some ETFs, like SPY, the S&P 500 ETF, collect all the dividends paid during the quarter and then pay it out at once. Others pay it out as it comes in to them. For example, tomorrow PPH, the pharmaceutical HOLDRs, pay a cash distribution of $3.96 because of the merger of Wyeth (WYE) and Pfizer (PZE). And the CBOE is adjusting the option contracts to reflect that special payment.

Here is a screen shot of the November series options (Click on the image to enlarge):

PPH is trading at 68.39 / 68.4 and the Nov 70 put is 2.1 / 2.35. The intrinsic value of the put is 1.6 so the remaining fifty to seventy five cents reflects the time value to expiration. There are 32 days until the November options expire and theta is a penny and one half, so that is $0.48. There is a regular dividend payment of $0.009 cents with ex dividend date Thursday the 22nd of October. Too small to be seen with the naked eye.

Looking at the Oct puts, the 55 strike put is selling for 4.7 bid 6.2 ask. Since TDG is trading at 49.65, the intrinsic value of the put is 5.35. But there is a huge dividend to be paid, so it looks like one could buy the put for 6 and the stock for 49.65 for a total of 55.65. Tomorrow, one could put the stock for 55 and recover all but 0.65 and receive the dividend of $7.65.

This doesn’t seem possible, so I have a call in to investor relations to see if they are still planning to pay the dividend.

4:10 PM I just spoke to investor relations. He explained to me that Transdigm raised $425 million just to pay this dividend. They were brought public in 2006 by Warburg Pincus. Warburg has no more stock in TDG so they were not the ones insisting on a big payout. I wish he had called before the close, I would have bought more stock and puts.

Here is the closing price data from Thinkorswim:

On Tuesday 15th September, Phillip Morris declared what the dividend would be. That takes most of the uncertainty out of the payment on 9th October. To make any money we have to take on some risk. So putting on the position on Monday the day before, we could buy shares and sell in the money calls. Since the stock was at 47, I picked the 46 call to sell.

To make the trade delta neutral, one would have to sell 13 calls for every 1,000 shares bought. That is probably the right way to do it. Unless one can show that there is interest in a stock when it is about to pay a dividend and there is an upward bias to the price. If that were true, then one can sell calls one for one and have a positive delta.

By the end of the week, 18th September, the time premium has disappeared in the Oct 46 call bid. That means that the call will be exercised next week, the day before the ex-dividend date, 24th Sept. In that case, one can close out the position, there is no more to be gained.

The return after paying the bid ask spread is $130 for the delta neutral position, a return of 0.28% for the week, and $220 for the straight buy write, 0.48% return. The dividend would have been $580.

Another possibility is to try this as a calendar spread. I will come back to this tomorrow.