New Study Finds Un-Exercised Options Worth Nearly Half a Billion Dollars Over Ten Year Period, Bolstering Trader Profits
February 25, 2008
Media Contact: Amy Wolf
Senior Public Affairs Officer | Vanderbilt University
(615) 322-NEWS | amy.wolf@vanderbilt.edu
NASHVILLE, February 25, 2008 – Hundreds of millions of retail investor dollars are being left “on the table” because of carelessness or misunderstanding about the mechanics of call options, according to new research from the Vanderbilt Owen Graduate School of Management. The failure to exercise options leaves these profits exposed to professional traders, who are pocketing the overlooked cash.
The research, which appears in the current issue of the Journal of Financial Markets, analyzed call options on stocks with quarterly dividends of at least a penny over a ten-year period (January 1996 through June 2006) and examined irrational exercise decisions. Looking at the technical aspects of option holders’ decisions as well as the mechanics and risks of the positions of both small buyers and arbitragers, researchers discovered that more than half of these options – worth more than $491 million – went unexercised over that time period.
“We were shocked to see the vast amount of money that is being left behind,” said Robert E. Whaley, Valere Blair Potter Professor of Management at Owen. Whaley co-authored the paper with Owen Professor Hans R. Stoll and Veronika K. Pool of Indiana University’s Kelley School of Business. He notes that “some of the losses can be attributed to transaction costs, but a substantial portion is likely due to ignorance of call option mechanics, laziness in the monitoring of positions, or simple irrationality.”
Misunderstanding the mechanics of call options
In the United States, exchange-traded options are unprotected from cash dividend payments on the underlying stock. On ex-dividend day, the stock price falls by the dividend amount, making it advantageous to exercise “deep in-the-money” call options the day before on stocks whose dividends outweigh the remaining value of the option.
But many investors neglect to exercise their options, a failure that has not gone unnoticed by trading professionals who systematically collect the foregone profits by gaming the system. Through a strategy called “dividend spread arbitrage,” market makers simultaneously buy and sell a large number of long and short in-the-money call options on the day before ex-dividend. At the end of the day, the arbitrager exercises the long positions and waits to be assigned shares of stock on the short positions. If the short call positions are not fully assigned because some call option holders fail to exercise, part of the arbitrager’s short call positions net a windfall gain when the underlying stocks go ex-dividend and the calls drop in price. This type of trading is so prevalent, the study finds, that the arbitragers “capture virtually all of the money left on the table – money that belonged to short call option holders on the day before.”
While this “casino-style” capitalism may be perfectly legal and, in some cases, encouraged by options exchanges eager for higher trading volumes, it’s not necessarily fair to investors. At particular risk are small investors, who “lack the time, money or expertise to track the event and are often careless about the details of their holdings,” the study finds.
A wake-up call for investors
Whatever the reason for the failure to exercise, Whaley believes that greater efforts by exchanges and brokers to provide more guidance may mitigate future losses. In the study, he recommends several changes that might make the system fairer. “Brokers could share more information with their clients, such as e-mail alerts to those holding positions before ex-dividend day,” the paper states. In addition, “clearing corporations could also 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.”
Above all, Whaley says he hopes the findings encourage investors to pay more attention to their holdings. Given the large amount of money at stake, “small option traders should 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,” he said.
The study, “Failure To Exercise Call Options: An Anomaly And A Trading Game,” appeared in the February 2008 edition of the Journal of Financial Markets. A PDF of the research is available for download through the Social Science Research Network.
Vanderbilt Owen Graduate School of Management is ranked as a top institution by BusinessWeek, The Wall Street Journal, U.S. News & World Report, Financial Times and Forbes. For more information about Owen, visit www.owen.vanderbilt.edu
