Options & Dividends: When to Optimally Exercise

There are two ways for a trading idea to be big enough to make it worthwhile. It can have depth or breadth. Index options have depth but there aren't many indices to trade. Equity options have more breadth. There are currently over 3000 companies with listed options and, although liquidity drops off fast after the top few hundred, equity options are worth trading. 

They have a few unique wrinkles and here I'll be looking at one: dividends.

It is well known that holders of American calls should exercise these just before a dividend is paid if the dividend value is greater than the option's remaining time value. This is optimal because, while you lose the remaining optionality, you receive the dividend. But in reality, many traders don't do this. Numerous studies document that up to 50% of options are either exercised at the wrong time or not exercised at all. And there is a simple way to make money from this. Buy a deep call spread. Exercise your longs to receive the dividend and assume that not all of your shorts will be exercised. You pocket the dividends from the unexercised part.

A similar idea applies when trading index options. If you can choose between selling an American or a European option, choose the American. The incorrect exercise decisions of the longs mean that Americans are a little over-priced. 

Is this effect enough to constitute a stand-alone strategy. No. But almost nothing is and if we don't take every little edge we will never succeed.

Euan SinclairComment