It is a trade desgined to profit from less sophisticated traders. But apparently the dividend options trade proved too sophisticated for Merrill Lynch, a division of Bank of America. On September 21 Merrill Lynch lost upwards of $10 million on a trade designed to capture dividends from an exchange-traded fund that tracks the S&P 500 Index.
The dividend options strategy involves the buying and selling of call options just prior to the ex-dividend date. It is designed to take advantage of smaller and/or less sophisticated options investors who fail to exercise in-the-money calls prior to the ex-dividend date. After a security goes ex-dividend, the value of existing call options drop. An investor who fails to exerice call options prior to the ex-dividend also fails to qualify to collect the dividend.
According to this Wall Street Journal article, a source claims that Merrill Lynch double processed a client’s dividend options orders. The client’s trade unded up being profitable. Since the “duplicate” orders were losers, we can only assume that only a portion of the client’s trade was doubled.
WSW Lesson: If you have an in-the money call option for a dividend-paying security, sell it or exercise it prior to the ex-dividend date. To understand how big traders are profiting from your complacency, follow the link to the ISE White Paper, below.
Sources and Coverage:
The Wall Street Journal by Kaitlyn Kiernan BofA Options Loss Reignites Debate on Controversial Strategy
International Secuities Exchange White Paper, Dividend Trade Strategies in the U.S. Options Industry
CNBC, Dividend Play In S&P 500 ETF Goes Awry, Costing Traders $29 Million