Market Sentiment: Option buying at historical level, second only to April 2010

December 2010 seems to be month when all the stars align, and bullishness is reaching historical extremes. Here's what we have reached this December 2010:

1. No New Normal Next Year Seen by Strategists Predicting 11% Gain in S&P 500
2. Hedge Funds Raise Commodity Gain Bets to 4-Year High
3. Put Call Ratio: Everyone’s Betting On The Bull
4. Volatility is back to April 2010 levels
5. Rydex Nasdaq 100 Bull/Bear Ratio At Highest Since Dot Com Collapse
6. US CEOs Most Optimistic since 2006
7. Extreme bullishness in emerging countries, money pouring into stocks at the fastest pace since 2007, biggest rally in 16 years
8. SentimentTrader.com: Equity Hedging Index is at a new record low
9. Trading of U.S. stock options soared to the second-highest level in nearly four decades of history

Please also note that the put/call ratio is dangerously approaching the historically low level of April 2010.

Dec. 17 (Bloomberg) -- Trading of U.S. stock options soared to the second-highest level in nearly four decades of history yesterday, boosted by investors using the contracts to capture dividends paid by the biggest exchange-traded funds.

Volume jumped to 30.7 million contracts on stocks, indexes and ETFs, according to Chicago-based Options Clearing Corp., which clears and settles all trades in exchange-listed contracts. The SPDR S&P 500 ETF Trust, which tracks the benchmark measure of U.S. stocks, accounted for about a third of that volume. The record of 30.8 million was set on May 6, when U.S. stocks lost $862 billion in value in less than 20 minutes.

Traders who bought options to receive quarterly dividends from ETFs drove yesterday’s transactions, said Henry Schwartz, president of Trade Alert LLC, a New York-based provider of options-market analytics. The S&P 500 ETF and others began trading today without the right to receive a dividend.

“Dividend-trading activity is how professionals harvest money that’s left up for grabs,” Schwartz said. Owners of in- the-money calls have the right to receive the underlying security from the contract’s seller, who must deliver the shares at the strike price. Call owners may exercise the options before the ex-dividend date to get the dividend, and most do, he said.

Yesterday’s most-active single contract was the Financial Select Sector SPDR Fund’s December $15 call, which traded 1.89 million times, a 15-fold increase over the four-week average for all calls on the ETF, according to data compiled by Bloomberg. The ETF tracking banks and brokers closed at $15.53 today.
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Options began trading in the U.S. on an exchange when the Chicago Board Options Exchange started on April 26, 1973. There were 1.1 million contracts traded that year. Volume first exceeded 100 million contracts in 1981. Trading reached 1 billion in 2004 and 2 billion in 2006.
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Unclaimed dividends are assigned to traders who sold call options that were not exercised. The amount they receive depends on the number of contracts they are short and the percentage of the total number of open contracts that were not exercised before the ex-date. If 95 percent of in-the-money options were exercised, the dividends for the remaining 5 percent would be distributed to the sellers of the unexercised options.

By simultaneously buying and selling equal numbers of new call options on the last possible day, a trader can drive up the so-called assignment rate for unclaimed dividends to 99.9 percent and receive more of the unclaimed dividends, Schwartz said.

The strategy “takes advantage of the way the assignment process works,” Schwartz said. “And it lets traders accumulate those dividends that would’ve otherwise been assigned at a 95 percent rate.”

ISE called the dividend capture trades “objectionable” in a March report and said that it doesn’t support the practice because it benefits institutional investors at the expense of individuals.

“Not only does this strategy distort market share with millions of contracts, but it also takes advantage of the fact that individual options traders -- who may lack sophistication or resources -- will fail to exercise their deep in-the-money call options in order to collect a corporate dividend payment,” ISE said.