By Ann Saphir and Doris Frankel
CHICAGO (Reuters) - A specialized trading strategy known as dividend trades harms markets, misleads investors, and should not be included in overall reports of trading volume, the International Securities Exchange said on Monday.
So-called dividend spread trading accounted for nearly 4 percent of U.S. options trading last year, ISE said.
Inclusion of the trades inflated the reported market share of some options exchanges and negatively affected ISE's market share, the options market said in an 11-page paper on the practice posted on its Website on Monday at: http://www.ise.com/dividendtrades .
ISE, which is owned by Deutsche Boerse AG's <DB1Gn.DE> derivatives exchange Eurex, has been a vocal critic of so-called ex-dividends trades for years.
ISE said its overall market share fell to 22.8 percent in February from 22.9 percent in January and 28.3 percent in February 2009.
Daily average trading at ISE fell 17.4 percent to 3.1 million contracts last month from 3.8 million a year earlier.
Trading at the Chicago Board Options Exchange, ISE's bigger rival, was flat compared to a year earlier, at 4.2 million contracts a day, the market said separately. Its market share rose to 30.1 percent, up from 29.6 percent in January, but slipped from 31.5 percent a year earlier.
Trading at all U.S. options markets rose 2.3 percent in February from a year earlier, the Options Clearing Corp said.
Excluding dividend trading, ISE said its February market share in equity options would have been 25.3 percent, more than the 24.6 percent it reported.
"Dividend trade strategies do nothing more than 'paint the tape,' creating the appearance of healthy order flow," the ISE said.
"For the individual investor who has been trained to associate high trading volume with news in the individual stock, these trades are very misleading."
ISE said if dividend trades are removed from industry growth calculations for 2008 and 2009, U.S. equity options volume actually shrank by 0.1 percent for 2009 compared to 2008.
The dividend spread play is a strategy professional traders use to capitalize on less savvy investors who fail to convert their options into shares in time to take advantage of the limited time period that dividend payments are available.
The plays occur one day prior to ex-dividend date -- the point when a buyer is no longer entitled to the company's payout.
That is when professional options traders pair up and agree to buy and sell to each other huge numbers of call options -- contracts that give the right to buy a company's shares at a fixed price by a certain date.
Market makers exercise -- that is, convert into stock -- the in-the-money call options they own and thereby acquire the shares in time to collect the dividend.
Theoretically, because they have also sold in-the-money calls, they are also on the hook to deliver shares to any call option holders who also exercise.
But because a notable number of nonprofessional traders fail to exercise their options in time, the professional traders end up with more shares of dividend-paying stock than they are required to deliver.
The trades are legal, and typically take place at markets such as former Philadelphia Stock Exchange, now called Nasdaq OMX PHLX <NDAQ.O>, where fee caps reduce costs.
"ISE has never supported these types of trades through the use of fee caps, and as a result, they do not occur here," the report said.
(Editing by James Dalgleish and Tim Dobbyn)