Another Kind of Arbitrage: Ex-dividend Option

By TENNILLE TRACY in WSJ 10-10-2009

A complex options trade that pits sophisticated traders against normal investors is gaining in popularity.

While any investor can conduct the options trade, known as a "dividend spread arbitrage," the reality is that professional traders -- namely, market makers who buy and sell options for a living -- have an advantage over smaller investors.

The trade is rising in prominence at a time when U.S. securities regulators are scrutinizing certain trading practices, such as those involving lightning-fast trading systems, that may place certain investors at an unfair disadvantage.

The dividend-spread-arbitrage trade is conducted in the options of companies that are about to issue dividends and has become more common as exchanges in recent years have taken steps to limit trading fees.

Specifically, the trade takes place on the day before a company's stock goes "ex-dividend," when a company compiles a list of its shareholders for the purposes of issuing a dividend. Since a company's stock will typically drop in price after this date -- usually by the amount of the dividend -- the company's call options, which convey the right to buy the stock, also will decline in value.

Market makers who know how the event affects options try to take advantage of the situation by selling call options they don't own with the goal of buying them back later when the options are cheaper. The trade is considered controversial in part because it takes advantage of investors whose calls haven't been exercised before the ex-dividend date.

"The amount of money left on the table [is] a crying shame and part of it is because brokers don't tell their customers to exercise," said Jud Pyle, a market analyst with PEAK6 Investments.

The trade also prompts debate because retail, or individual, investors find it nearly impossible to do. Unlike market makers, individual investors aren't allowed to maintain short and long positions in the same option -- often a crucial component of the transaction. And individual investors typically lack the resources to buy and sell thousands of contracts at once, another characteristic that makes the trade worthwhile.

Anatomy of the Trade

This is how the trade often works: Market makers will buy and sell thousands of call options in a company whose stock is poised to go ex-dividend. Usually trading between themselves, they establish long and short positions in the same option. But before the session ends, the market makers will exercise the calls they bought while maintaining short positions in the calls they sold.

On July 28, for example, one day before ConocoPhillips went ex-dividend, traders appear to have bought and sold thousands of August $38 calls in the energy company. Before the session ended, the traders who conducted the arbitrage trade would most likely exercise the August $38 calls they bought and maintain short positions in August $38 calls they had sold.

That night, Options Clearing Corp. would process the day's trades. For every investor who had exercised a call option they owned, the OCC would randomly assign the contract to an investor who was short the call option. Invariably, the OCC would assign some of the options to the traders who were short. But for every option in which they were able to stay short, the traders could buy it back at a cheaper price.

In order for the trade to work, investors who own the call options -- often individual investors -- have to hold on to them through the ex-dividend date. That is because investors who exercise their call options force the OCC to assign the options to traders who are short and thereby eliminate the potential for arbitrage.

In theory, all investors who own "in the money" call options should exercise their contracts before ex-dividend dates. By doing so, they unwind out of options that are about to decline in value and take ownership of stock that is about to issue a dividend. In reality, however, several investors fail to exercise and for various reasons: they aren't monitoring ex-dividend dates or because it isn't economically feasible to do so.

While some question the fairness of the trade, although not the legality of it, others say the trade is harmless and that market makers are merely collecting profits that would otherwise be wasted. "If there's a penny on the ground and I see it, should I not pick up the penny?" said Phil Gocke, president of the options trading company Brite Sky LLC.

Exchanges' Tension

The dividend trade has become a bone of contention among the various options exchanges -- namely between those that play host to the trade and those that don't.

The OCC and the Securities and Exchange Commission have reviewed the trade and haven't imposed any restrictions on it, exchange officials said. "It's not an exchange's obligation to deem what is proper or fair," said Ed Boyle, head of NYSE Euronext's U.S. options division. "That's the job of the regulators."

The International Securities Exchange, one of the largest options exchanges in the U.S., says the trade poses a systemic risk to the industry and should be curbed. "It could become an issue and the industry needs to do something about it," said ISE Chief Executive Gary Katz. "Not because something has gone wrong but because it is time to fix a problem that nobody wants to address."

The Greenback Effect by Warren Buffett 8-19-2009

The Greenback Effect

By WARREN E. BUFFETT

Published: August 18, 2009

http://www.nytimes.com/2009/08/19/opinion/19buffett.html?pagewanted=1&_r=2&ref=opinion&adxnnlx=1250705844-LfABFNPAbeHVZXcsKqynpg

IN nature, every action has consequences, a phenomenon called the butterfly effect. These consequences, moreover, are not necessarily proportional. For example, doubling the carbon dioxide we belch into the atmosphere may far more than double the subsequent problems for society. Realizing this, the world properly worries about greenhouse emissions.

The butterfly effect reaches into the financial world as well. Here, the United States is spewing a potentially damaging substance into our economy — greenback emissions.

To be sure, we’ve been doing this for a reason I resoundingly applaud. Last fall, our financial system stood on the brink of a collapse that threatened a depression. The crisis required our government to display wisdom, courage and decisiveness. Fortunately, the Federal Reserve and key economic officials in both the Bush and Obama administrations responded more than ably to the need.

They made mistakes, of course. How could it have been otherwise when supposedly indestructible pillars of our economic structure were tumbling all around them? A meltdown, though, was avoided, with a gusher of federal money playing an essential role in the rescue.

The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.

To understand this threat, we need to look at where we stand historically. If we leave aside the war-impacted years of 1942 to 1946, the largest annual deficit the United States has incurred since 1920 was 6 percent of gross domestic product. This fiscal year, though, the deficit will rise to about 13 percent of G.D.P., more than twice the non-wartime record. In dollars, that equates to a staggering $1.8 trillion. Fiscally, we are in uncharted territory.

Because of this gigantic deficit, our country’s “net debt” (that is, the amount held publicly) is mushrooming. During this fiscal year, it will increase more than one percentage point per month, climbing to about 56 percent of G.D.P. from 41 percent. Admittedly, other countries, like Japan and Italy, have far higher ratios and no one can know the precise level of net debt to G.D.P. at which the United States will lose its reputation for financial integrity. But a few more years like this one and we will find out.

An increase in federal debt can be financed in three ways: borrowing from foreigners, borrowing from our own citizens or, through a roundabout process, printing money. Let’s look at the prospects for each individually — and in combination.

The current account deficit — dollars that we force-feed to the rest of the world and that must then be invested — will be $400 billion or so this year. Assume, in a relatively benign scenario, that all of this is directed by the recipients — China leads the list — to purchases of United States debt. Never mind that this all-Treasuries allocation is no sure thing: some countries may decide that purchasing American stocks, real estate or entire companies makes more sense than soaking up dollar-denominated bonds. Rumblings to that effect have recently increased.

Then take the second element of the scenario — borrowing from our own citizens. Assume that Americans save $500 billion, far above what they’ve saved recently but perhaps consistent with the changing national mood. Finally, assume that these citizens opt to put all their savings into United States Treasuries (partly through intermediaries like banks).

Even with these heroic assumptions, the Treasury will be obliged to find another $900 billion to finance the remainder of the $1.8 trillion of debt it is issuing. Washington’s printing presses will need to work overtime.

Slowing them down will require extraordinary political will. With government expenditures now running 185 percent of receipts, truly major changes in both taxes and outlays will be required. A revived economy can’t come close to bridging that sort of gap.

Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes. In fact, John Maynard Keynes long ago laid out a road map for political survival amid an economic disaster of just this sort: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.... The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

I want to emphasize that there is nothing evil or destructive in an increase in debt that is proportional to an increase in income or assets. As the resources of individuals, corporations and countries grow, each can handle more debt. The United States remains by far the most prosperous country on earth, and its debt-carrying capacity will grow in the future just as it has in the past.

But it was a wise man who said, “All I want to know is where I’m going to die so I’ll never go there.” We don’t want our country to evolve into the banana-republic economy described by Keynes.

Our immediate problem is to get our country back on its feet and flourishing — “whatever it takes” still makes sense. Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

Jim Rogers: Best advice I ever got

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Dear VICtors,

Do you like to have similar results as what Jim Rogers got ? Do what he said ( see the article forwarded by Soumen)

Now, are you ready to read annual report written by Warren Buffett?

7/14 and 7/28: BRK 2008 annual report http://www.berkshirehathaway.com/2008ar/2008ar.pdf

Starting from Aug, we will read FORTY YEARS A SPECULATOR by FRED CARACH together. Please order it now.

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Best advice I ever got

Jim Rogers: Read everything

Age: 66

Investor and commodities guru

The best advice I ever got was on an airplane. It was in my early days on Wall Street. I was flying to Chicago, and I sat next to an older guy.

Anyway, I remember him as being an old guy, which means he may have been 40. He told me to read everything. If you get interested in a company and you read the annual report, he said, you will have done more than 98% of the people on Wall Street.

And if you read the footnotes in the annual report you will have done more than 100% of the people on Wall Street. I realized right away that if I just literally read a company's annual report and the notes -- or better yet, two or three years of reports -- that I would know much more than others. Professional investors used to sort of be dazzled.

Everyone seemed to think I was smart. I later realized that I had to do more than just that. I learned that I had to read the annual reports of those I am investing in and their competitors' annual reports, the trade journals, and everything that I could get my hands on. But I realized that most people don't bother even doing the basic homework. And if I did even more, I'd be so far ahead that I'd probably be able to find successful investments.

--Interview by Brian O'Keefe

CBOE Launches Options on 'Baby Berkshires'

6/19/2009 WSJ

NEW YORK -- Options exchanges have started to list options on Warren Buffett's Berkshire Hathaway, allowing investors to speculate on a stock that trades for thousands of dollars per share.

Berkshire Options: Don't Believe the Hype

Investors should steer clear of Berkshire Hathaway options for now, advises Barrons.com columnist Steve Sears. A better option? Sip a can of Cherry Coke.

The Chicago Board Options Exchange launched trading on the options Thursday, becoming the first exchange to do so. The options convey the right to buy and sell shares in Berkshire Hathaway's Class B stocks, also known as Baby Berkshires.

Those shares closed Thursday's session at $2,829 -- losing $45 or 1.6%. They represent the most expensive stock on which options at the CBOE are traded.

Another options exchange, the Philadelphia Stock Exchange, plans to follow suit and is scheduled to list options on Berkshire Hathaway on Monday, said a spokeswoman from Nasdaq OMX, which owns the exchange.

While investors typically use options to participate in market activity without having to put up large amounts of cash to do so, the options on Berkshire Hathaway are relatively expensive.

A VALUE PLAY? The Chicago Board Options Exchange and the Philadelphia Stock Exchange are getting into the game of listing options on Berkshire Hathaway's B shares. Here, Berkshire's Warren Buffett in May.

The July $2,800 call options, for example -- the most popular contract on Thursday -- closed at $110.90. And since options convey the right to buy or sell stock in lots of 100 shares, that means just one of the July calls would cost $11,090. Calls convey the right to buy the stock, while puts convey the right to sell it.

Since the contracts are so expensive, they will most likely attract a roster of sophisticated investors with lots of capital to manage.

Some strategists said investors might want to consider selling put options in Berkshire Hathaway. That way, they can collect a premium from the sale and use the proceeds to help offset the cost of the pricey shares.

"These options are probably a better sale than a buy," said Oppenheimer & Co. chief options strategist Michael Schwartz. "If you sell the puts, you effectively buy the stock at a discount."

The Berkshire Hathaway options mark an evolution in the options industry, whereby market makers -- professional traders who take the other side of investors' orders to buy and sell the options -- feel capable of managing the risks associated with such expensive contracts.

Barclays's Barclays Capital is serving as the designated primary market maker for the options traded on CBOE, while Susquehanna Financial Group will serve that role for contracts traded on the Philadelphia exchange.

Because of the risks the market makers shoulder -- namely, having to quote prices for options whose values could quickly change by several dollars -- CBOE granted Barclays Capital a type of waiver. While CBOE typically forces market makers to quote bids and offers within $5 of each other, they removed that requirement for Barclays.

As a result, the prices at which investors can buy and sell the options could be noticeably different.

Recommended books to read by club advisors

FORTY YEARS A SPECULATOR by FRED CARACH

Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger, Expanded Third Edition

One up on Wall Street: How to Use What You Already Know To Make Money in the Market, Miniature Edition by Peter Lynch and John Rothchild

Way of the Turtle: The Secret Methods that Turned Ordinary People into Legendary Traders by Curtis Faith

Trend Following: How Great Traders Make Millions in Up or Down Markets, New Expanded Edition, (Paperback) by Michael W. Covel

Tight Spot for Fed, Blind Spot for Investors

A combination of growth optimism and inflation fear has catapulted asset markets in the past few weeks. These two concerns should drive markets in different directions: Inflation fear, for example, should limit room for stimulus and prompt stock markets to retreat. But the investment camps expressing these opposite concerns go separate ways, each pumping up what seems believable. As a result, stock and commodity markets are mirroring the behavior seen during the giddy days of 2007.

* you can find the rest on http://english.caijing.com.cn/2009-06-09/110180019.html

Article recommended by Bill Cai

Credit Relief May Not Last Long

Interesting to read what happened to the big banks after the rise in interest rates from 1977-1984. This is inside the article below

In 1980, recalled Henry Kaufman, who then was Wall Street’s most influential economist as the bond market guru at Salomon Brothers, “the financial malaise was in the big institutions, because they had been lenders to Latin America, but it was not as widespread as it is today.”

In the end, many of the big American banks of that era were replaced by a crop of growing regional banks that had not made the same mistakes. The old Bank of America was folded into NCNB, which took the old name but not most of the old management. Wachovia, another North Carolina bank, grew to be a major player. Citicorp was absorbed into Travelers, becoming Citigroup. Now Wachovia is gone, absorbed into Wells Fargo after it faltered, and Citigroup survives as a government ward.

In baseball terms, the financial system had a good crop of minor leaguers available when the big league stars went onto the disabled list in the 1980s. Now the minor leaguers are also battered and bruised.

You can read the whole article below.

Credit Relief May Not Last Long

May 29, 2009, 7:20 am
http://dealbook.blogs.nytimes.com/2009/05/29/credit-relief-may-not-last-long/