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January 1, 2013

Going It Alone

Dividend Trades Cease at Three Options Exchanges

By Peter Chapman

The controversial practice of dividend-capture options trading has ground to a halt at three of the four floor-based exchanges that have offered it.

According to data published by the International Securities Exchange, dividend trade volume disappeared at NYSE Arca, NYSE Amex and the Chicago Board Options Exchange in November.

Dividend-capture trading is still practiced at Nasdaq OMX PHLX, according to the ISE data, a fact that rankles at least one industry official opposed to the practice because of the operational risks posed.

Steve Crutchfield

"We are very gratified that several other exchanges have recently joined with ISE in eliminating support for this trading strategy," said ISE president and chief executive Gary Katz. "However, as long as there are exchanges that facilitate and encourage dividend trades, they will continue to pose a completely unnecessary risk to the options market and damage investor confidence."

The disappearance of dividend trades at the three exchanges followed moves by all three in late October to eliminate the caps they had on fees charged for such trades. Eliminating the caps largely eliminated the pricing incentive-a volume discount-to do the huge trades in the first place.

The decision by the exchanges to eliminate the incentives came in the wake of an incident in September when a clearing firm reportedly lost millions of dollars handling dividend-trades in SPDR S&P 500 ETF (SPY) options. The Dow Jones News Service reported that the Merrill Pro division of Bank of America Merrill Lynch lost $10 million on those options. The bank would neither confirm nor deny the report, although speculation is that a clerical error occurred.

The three exchanges filed their fee changes with the Securities and Exchange Commission in late October, citing concerns over "operational risk."

"We had been looking askance at this activity for some time," Steve Crutchfield, in charge of NYSE Euronext's options business, told Traders Magazine.

"But collectively, the industry skated on this. This problem could have been much, much bigger. In our view, as long as these trades continue to happen, there is operational risk out there that needs to be addressed," he said.

In a rule-making proposal filed Oct. 26, the CBOE told the Securities and Exchange Commission it did not want to provide brokers with an incentive to conduct the trades "because this strategy may encourage high volumes of trading of certain securities near the ex-dividend date and present operational risks to market participants with respect to clearing, exercise and assignment or other issues that may prevent the market participant from the timely exercise of call options and collecting the dividend owed."

Concern over the practice has been building for years. The ISE has long been an outspoken critic, claiming the trades distort industry volume patterns, harm individual investors and present the practitioner with great risk for little gain.