Monday, October 5, 2009

Caterpillar (CAT) - Doing your homework might pay dividends

-- written by "Lane"; Professional NYSE ARCA Options Market Maker

A quick glance at CAT’s dividend history shows a long steady history of quarterly dividends paid in January, April, July and October. More digging shows that over the past four years the stock has gone ex-dividend prior to the option expiration date every quarter. Furthermore, since January 2000, CAT has paid 39 quarterly dividends. Of those 39 dividend distributions, only four times has the ex-dividend date for the distribution been after the expiration date. That is some compelling evidence that CAT will go ex-dividend prior to October expiration. Feeling pretty confident that the ex-dividend date for October’s dividend is before October expiration? Even Bloomberg would tell you this is the case (image below is copyrighted by Bloomberg, and all that legal stuff).

What odds would you give me to take the other side?

After some significant research cross referencing the dividend stream on the Caterpillar website, here is what I have found. Dating all the way back to 1996, in October the dividend is consistently declared on the second Wednesday of the month. The shortest time period between the declaration date and the ex-dividend was not less than six calendar days after the declaration date.

What does that mean for the anticipated October dividend? The second Wednesday of October is October 14, I then add, at a minimum six calendar days to that and I am at an ex-dividend date not before the October 20, which falls after October expiration, October 16. Livevol is projecting the ex-date after Oct expo:

For comparison I looked for another expiration month which had dates similar to October 2009. I found April 2004. The second Wednesday of the month was the April 14, the dividend was declared on that day with an ex-dividend date of April 22 which fell after April expiration. My odds might be getting a little better.
How I am trading it.

I decided to isolate my trade as much as possible to a binary wager. There is or is not a dividend prior to October expiration. To do this, I chose to put on a reversal in October. Without getting terribly academic, if the market is pricing in a dividend amount greater than I am forecasting, then compared to my values, the market’s put values would be relatively expensive and its call values relatively inexpensive. This would lead me to buy calls, sell puts and sell stock (to remove the delta risk). These three trades are the three legs of a reversal.

Risk reward ratio
If the stock goes ex-dividend prior to October expiration and the dividend is $.42 then I would need to receive about $.42 in order to breakeven (before transaction costs) on a reversal, being short the stock I would be responsible for paying that dividend. If, however, the stock goes ex-dividend after expiration of my October position, any premium, above my transaction costs, I received to do the reversal would be profit.

When I started putting this trade on a little over a week ago, I was receiving about $.25 to reverse in October. Based on the closing marks in CAT from Friday October 2, 2009 the midpoint of the October reversal/conversion market was about -$.15. In terms of risk/reward for reversing, the risk is now approximately $.27 (.42 dividend -.15 received) to make $.15. The October reversal is laying roughly 2/1 on the trade right now. Is there greater than a 67% chance that the dividend is after October expiration? If so, then there is still edge in reversing for $.15, but the cost of being wrong is going higher.

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