The High Cost of Failing to Exercise Options

Retail Investors Lose Half a Billion Dollars As Market Makers Pick Up Options Profits

Bob Whaley A quirk in the system of trading stock options, coupled with small investor ignorance or carelessness, has cost option holders nearly half a billion dollars over a ten-year period. Their failure to exercise call options when stock dividend payments make it optimal to do so leaves their profits exposed to expert traders who clear the table as swiftly and surely as Vegas croupiers.

PHOTO: Bob Whaley, Valere Blair Potter Professor of Management (Finance); Co-Director of the Financial Markets Research Center

"I was stunned by the sheer amount of money left on the table," says Robert E. Whaley of Vanderbilt Owen Graduate School of Management. His paper, "Failure To Exercise Call Options: An Anomaly And A Trading Game," written with Owen colleague Hans R. Stoll and Veronika Krepely Pool of Indiana University, is the first to take a comprehensive look at the phenomenon.

The key trigger is "ex-dividend day," which makes possible a "sting" that is perfectly legal and is in fact encouraged by options exchanges eager for the huge trading volume necessary to pull it off. On that day, the stock price falls by the dividend amount, making it advantageous to exercise options the day before on stocks whose dividends outweigh the remaining value of the option.

Podcast Interview: Professor Whaley discusses his research on call options with Rob Simbeck (recorded on July 20th, 2007).

Small investors, generally without the time, money, or expertise to track the event and often careless about the details of their holdings, may simply miss the chance to cash in on time.

"About half of the options that should be exercised just before a given ex-dividend day are not," says Whaley.

Until the close of trading the day before ex-dividend day, however, their potential profits are up for grabs. "Market makers" skilled in such matters simultaneously buy and sell huge numbers of contracts in in-the-money call options in a strategy called "dividend spread arbitrage." Since the long and short positions are in exactly the same contract, the position has no risk. Later that day, the arbitrager exercises the entire long call position, as he should, and then waits to be assigned shares of stock on the short call position. If the short call position is not fully assigned because some call option holders fail to exercise, part of the arbitrager’s short call position nets a windfall gain when the stock goes ex-dividend and the call drops in price. By selling thousands upon thousands of these call option contracts on the day before the ex-dividend day, the arbitrager acquires a disproportionately large share of all open short positions and consequently, by virtue of random assignment, a disproportionately large share of the money left on the table.

Several factors contribute to the scenario. First, stock options traded in the U.S. are American-style, which means they can be exercised at any time prior to expiration, unlike European-style stock index options, exercisable only at expiration. The early exercise feature of stock option contracts is what makes this kind of arbitrage and system gaming possible. Second, if the stock pays no dividends, the call option will never be optimally exercised before its expiration and no dividend spread arbitrage opportunities would be created. Finally, the cost of trading is much higher for the small investor on a percentage basis, particularly because of the buy/ask spread—arbitragers can, by agreement, operate in the middle, further reducing their costs—and because the Philadelphia and Pacific option exchanges both cap trading costs after a certain volume, a big trader can buy 100,000 options as cheaply as 1,000.

"The way the exchanges are judged relative to each other is by trading volume," Whaley says, "and the amount of trading volume in an in-the-money call option on the single day prior to the ex-dividend day is often higher than that of the entire rest of the month. Indeed, the shares changing hands through call option trading on that day frequently exceed the shares changing hands in the underlying stock market."

Whaley and his colleagues studied a sample of call options on stocks with quarterly dividends of at least a penny between January 1996 and April 2006. They examined irrational exercise decisions and looked at the technical aspects of option holders' decisions as well as the mechanics and risks of the positions of both small buyers and arbitragers. They also noted that market makers accounted for 73% of the dividend spread arbitrage activity during the period, and member firms accounted for 23%.

The phenomenon had been difficult to analyze until recently because of a lack of good sources of comprehensive data on the options markets. The fact that OptionMetrics in New York has begun vending data to academic institutions gave Whaley and his co-authors such a source of data for the study.

"It started out as just a simple investigation of a particular call option trading strategy, but I was shocked by what we found,” says Whaley. "This is really not a new topic. In fact, a book I wrote with Hans Stoll in 1993 describes how it's done. It's becoming more important now because some options exchanges are actively promoting the activity by capping fees on such trades. And, it's clear that at least some small traders still do not fully understand what they're trading. Whaley says he hopes his findings "might encourage small option traders to think a little more carefully about what's going on with their call option positions and about whether they're behaving the way they should when dividend events occur.”

Whaley does have recommendations that might help make the system fairer, although he makes them knowing the chances of their adoption amid this casino-style capitalism are slim. One is that brokers share more information with their clients, perhaps sending e-mail alerts to those holding positions before ex-dividend day. A second involves having clearing corporations insist that arbitragers net their positions at the end of the day before exercise assignment, thereby eliminating the market maker’s ability to carry out dividend spread arbitrage.

"The former would be relatively easy to do," he says, while agreeing the latter "will not happen."

"It's not right, but the reality is that it's not going to change," he says. "These guys have a strong economic incentive to engage in this activity. I've talked to people who do it and their counterargument is, 'I can't explain why some traders aren't rational enough to exercise their options when they should, but, given their behavior, we'll take advantage of it.'"

Another suggestion is a last-in first-out assignment. Under such a procedure, delivery assignment of exercised calls would go to the shorts who most recently entered their positions. But, this alternative would also stand little chance, says Whaley, who termed it "a record-keeping nightmare."

The key solution—careful, well-thought-out trading on a large scale—is just as unlikely.

"If everyone was behaving rationally," he says, "they would all be exercising their options when they should and there would be no money on the table to fight over.”

Whaley himself admits to being prone to the very behavior he is attempting to discourage in others.

“One of the earliest academic papers I wrote was on this topic back in 1981," he says. "I know about what should happen to option prices on ex-dividend days. Yet, when I buy and sell call options, I don't pay attention to dividend payments on the underlying stock, simply because my monitoring costs are too high. I can't afford to sit around and follow the dividend payments of all these companies. I buy call options because I think, say, the price of Microsoft’s stock is going way up this month. I'm interested in the big move rather than the fine points. Lots of others are using the option market in the way I do, just taking a flyer."

The study held another interesting psychological study for him and one of his colleagues.

"When Hans Stoll and I began this study," he says, "he was of the view that this arbitrage activity by market makers was unfair because it was systematically expropriating the wealth of these small traders who should have been realizing the gains. My view was that, if the opportunity is there, why not take advantage of it? Well, after discussing it with him many times over the course of months, I've switched my view and he's switched his. I just think it's bad form. Market makers are systematically taking away the gains that other people would have had simply because their trading costs are lower. But, who sets the largest component of small investor trading costs—the option’s bid/ask spread? Market makers. To me, it does not seem fair. I suppose other people could define fairness differently."

The paper is an extension of Whaley's wide-ranging studies of the financial markets and the way theory meets reality.

"I tend to focus more on the investment side of things—how to value securities, how to value options contracts—then see how those ideas work in actual markets. I'm interested in the different structures of markets—that is, how things are traded. In this case, what drives the dividend play is a valuation issue. To understand its practical importance, we turned to market data. And in this case, the practical impact is simply carelessly lost money."

Send comments to bob.whaley@owen.vanderbilt.edu

Reported by Rob Simbeck