Chris Tyler, Optionetics.com
March 23, 2011

When it comes to risk profiles, the bull vertical or bull call spread looks an awful lot like a collar strategy which is comprised of equal parts long stock, long puts and short calls. If the two spread positions didn’t line up courtesy of a constant vigil by the markets arbitrageurs or rather computerized sharks these days; you’d have to think about Denmark and realize something fishy was going. In the end, the two are synthetic risk equivalents. They aren’t identical in every aspect though and as some traders in JP Morgan (JPM) learned this past week.

Last Friday JPM management announced a surprise (maybe) hike of 400% to its $0.05 quarterly dividend. A new payout of $0.25 per share and first such distribution to stockholders of record would commence on April 6. The immediate impact on JPM pricing was two-fold. First and as one might typically expect, shares of JPM found a bid on the session. As the more mathematically-inclined may note, the present value of a stock is deeply-linked to its future payouts; well, if the company does that sort of thing and all other factors being equal. Hence, if a dividend increase is announced and extraneous items like Libya, Japan and country defaults aren’t in the picture or sometimes even if they are, a stock will reflect the increase in value to shareholders.

Secondly, a dividend increase impacts the pricing of options. Without getting too fancy as I don’t hold a PhD but do maintain real world credentials of being involved with dividend pricing during time spent making markets in Philip Morris (PM); calls become cheaper and puts more dear following a raise to a company’s dividend.

The reason behind the pricing shift is derivatives are formulated using a hedge ratio i.e. delta neutral or contract neutral assumption. What this boils down to is the assumption of the trader buying a put and / or a short call also maintains long stock. As the synthetic short i.e. long put / short call doesn’t receive the dividend, it’s priced accordingly. This means many synthetic markets may trade at what looks like a discount compared to the underlying stock. But traders need to actually factor in the upcoming dividend payout and weigh the attached probability of assignment in order to better recognize the pricing and risks involved.

A derivative of this or maybe a second derivative of this synthetic pricing, pardon the pun, is the question of whether bankers in JPM wear collars? We know on one level the answer is “yes”, unless it’s a special dress-down work day around the office. Further, in looking at the conversion / reversal markets a couple days in front of Friday’s “surprise” dividend, it appears some bankers may have been pricing in the likelihood of a dividend boost by a few pennies. Thus, could some of those collars i.e. traders, been wearing collars to capitalize in more than one way?

Figure 1: JP Morgan (JPM) 10x Collar vs. Bull Call

Traders wishing to do some interesting homework can compare the “almost” risk free, delta neutral markets by looking at closing prices from Tuesday and Wednesday versus those on Thursday and whose conversion prices seemingly perked up just slightly in front of the actual news. Of course in seeing how a bunch of delta neutral spreads getting “put up” i.e. executed might likely alert the other side to something fishy being in the works; those possibly doing a bit of actual banking off the report were traders in JPM that were actually wearing collars other than the ones around their necklines.

In the end, both the likes of a collar and its bull vertical equivalent did fine in the dividend hike’s immediate aftermath. But as we look above and compare a ten lot collar versus a ten lot vertical designed as of last Thursday’s close and brought forward one session; it’s apparent not all is equal with these two strategies when it comes to pleasant surprises in the underlying other than price direction.

Chris Tyler
Senior Options Writer, former Market Maker & fulltime Option Hedge Hog Advocate
Optionetics.com ~ Your Options Education Site