Executive summary

This article highlights how market participants can use dividend index options and futures to efficiently manage and transfer dividend risk and the various trading methods available at CME Group for execution.

  • CME Group S&P 500 dividend Index futures and options provide traders with efficient tools to hedge dividend uncertainty, transfer risk, express market views or isolate dividend exposure while maximizing capital efficiencies.

  • Options can provide multiple ways to trade and manage exposures to risk events with an array of option expirations.

  • Market participants can now trade dividend index volatility directly through options structures as well as manage risks via delta hedged solutions.

  • Execution of Dividend Index futures and options has been made accessible through Globex, UDS (user defined spreads) and blocks which offer flexibility. 

  • In terms of liquidity, options on S&P 500 Annual Dividend Index futures have been developing average daily volume (ADV) liquidity to around 800 lots compared to the underlying futures’ of 4,000 contacts.


Introduction

The Federal Reserve began easing monetary policy for the first time in about four years with a 50-basis-point cut in interest rates on September 18, with investors expecting further easing through 2024 into 2025 to bring down rates from nearly two-decade highs. The Fed's move comes in the wake of inflation declining from over nine percent in 2022 to around 2.5% currently. 

Reducing borrowing costs amid steady economic growth can help to improve corporate earnings, allowing companies to maintain or increase dividends. Small-cap companies, in particular, could benefit from lower rates as they tend to depend on bank borrowings to fund operations unlike corporations that can tap bond markets. But if the rate cuts are a reflection of a weakening economy, companies could potentially face declining revenues, thereby leading to the potential for cutting dividends to preserve cash holdings. 

Amid this scenario, Dividend Index options can be a useful tool to hedge dividend uncertainty, transfer risk and isolate dividend exposure. There are numerous other strategies that can be pursued with these index options. Options on S&P 500 Annual Dividend Index futures (SDA) debuted in the U.S. for the first time as of January 29, 2024.

Demand has been growing over the last few years to trade and risk-manage U.S. dividend exposures in a transparent, standardized format via listed dividend futures and options[1]. Being exchange-traded and cleared helps mitigate counterparty risk, particularly important for derivatives and structured products users. 

Index dividend trading opportunities can appeal to a myriad of investor types: 

  • The buy-side and sell-side consisting of: banks, asset managers, hedge funds and proprietary trading desks 
  • Equity investors 
  • Relative value investors 
  • Liquidity providers and market makers
  • Macro investor 
  • Interest rate investors
  • Inflation desks

Typical use cases for options on S&P 500 Annual Dividend Index futures (SDA) include:

  • Managing and hedging directional dividend risk 

    • Using outrights[2]

    • Utilizing strategies such as calendar spreads, ratio spreads, or bull and bear spreads

  • Expressing volatility views 

    • Via straddles or strangles option strategies 

    • Executing a covered delta-neutral trade that allows for seamless delta transition and minimizes slippage on the retained delta


Managing dividend risks and exposures around dividend uncertainty

Where dividend uncertainty exists, investors will need to manage and incorporate:

  1. Pricing risk
    Market participants looking to capture the difference between implied and realized dividends can take directional views on dividends which are overvalued (sell) or undervalued (buy).

  2. Timing risk
    Using calendar spreads, investors can combine the buying and selling of dividends index contracts in different maturities and can also take views on dividend spreads between different years, particularly when implied dividends may be trading differently against forecast dividends.

  3. Liquidity risk
    As markets have evolved, the increased liquidity of Dividend Index futures has given investors the opportunity to directly access dividend exposure efficiently, irrespective of the price movement of the underlying benchmark index.

Market participants were recently forced to reconsider their risk and manage exposure when both Meta and Alphabet initiated paying dividends for the first time.[3]

  • This was expressed in both futures and options on S&P 500 Annual Dividend Index. Exhibit 1 illustrates the movements of the term implied volatility of the at-the-money options on the S&P 500 Annual Dividend Index futures at various dates.

  • Post announcements in 1H2024, the term structure of the volatility moved higher then subsequently normalized reflecting the market’s risk view as illustrated in Exhibit 1.

  • With the precision that options provide, market participants have multiple ways to trade certain events and can manage their risk exposures around company’s earnings announcements with an array of multiple option expirations.

Exhibit 1: At the money (ATM) implied volatility term structure for SDA options


Operational and capital efficiencies using options

When managing portfolio risk, operational and capital efficiencies can benefit options traders regardless of risk tolerance.

  • Centralized clearing allows market participants to offset their positions in listed futures and options, thus allowing for capital efficiency via portfolio margining. 

  • The ability to portfolio margin between futures and options may allow posting significantly less margin, which may also help to facilitate cross-hedging opportunities.

  • S&P 500 Annual Dividend Index futures and options margins are currently 2% – 3% and subject to change, allowing for optimized capital deployment.

  • Market participants may qualify for margin offsets with other contracts, including offsets specific to the underlying Equity Index futures.

  • CME CORE is an interactive margin calculator that enables you to determine and evaluate your initial margin requirements, run indicative margin requirements on all of our products.[4]


Liquidity expansion seen in the Dividend Index complex

  • The recent product innovation in options on S&P 500 Annual Dividend Index futures complements the Dividend Index futures and further enhances the scope of Equity Index complex.
  • Dividend Index futures ADV (average daily volume) in Q2 and Q3 exceeded 4.5K contracts while open interest (OI) averaged 320K contracts. This is equivalent to almost USD 6B in notional value.
  • Over 12K options on S&P 500 Annual Index Dividend futures contracts were traded on April 18, 2024, marking a single-day record.
  • Options on S&P 500 Annual Dividend Index futures have been developing ADV to around 800 lots compared to the underlying futures of 4,000.

Trading liquidity activity in index Dividend Index products is depicted in Exhibit 2.

Exhibit 2: ADV and OI on Dividend Index futures and options


Executing choices – CLOB and blocks

Movements in dividends can be captured by deploying various trading strategies. Market participants can use various execution choices to deploy their trades – both on the CLOB and as blocks

There is functionality that allows the delta to be assigned with execution of futures; thus when hedging options with futures, slippage can be minimized. 

Centralized Limit Order Book (CLOB)

Market participants can be flexible in their execution choice when trading Dividend Index options, choosing the Centralized Limit Order Book (CLOB) or as privately negotiated blocks, providing an alternative to the opaque OTC market. While pricing on the CLOB is anonymous and credit agnostic, the screen liquidity provided by market makers offers transparency of prices and indications of tradable size.

Options strategy flexibility 

On the CME Globex platform, traders can initiate various option strategies on screen, from simple "outright" trades to complex, multi-leg strategies to fine-tune Greek exposures near expiry. The platform supports user-defined options spreads (UDS) and request for quotes (RFQs), creating a central limit order book (CLOB) for each UDS. Traders can execute multi-leg strategies, utilize RFQs anonymously, and manage dynamic risks with up to 40 legs, helping mitigate "leg risk" and bid/ask spreads. RFQs complement screen liquidity and allow investors to source potential price improvements with zero commitment.

Example: CME Direct (CMED) exhibits healthy screen liquidity for dividend index options, as shown in the CLOB screenshot (Exhibit 3).

Exhibit 3: Screenshot of CMED highlighting screen liquidity on the CLOB

 

Block trading

  • Block trading liquidity enables market participants to transact larger sizes, minimizing slippage risk and while limiting market impact.
  • Privately negotiated and reported, block trades follow Rule 526 and can be executed between eligible counterparties.
  • Option block trades are often delta-neutral and involve synthetic combos.
  • Block transactions using options can be initiated where all of the various elements of the trade can be privately negotiated, consummated and reported – thus mitigating breakup risk.
  • Both screen and block trade structures allow delta management, with functionality to assign delta to a trade and minimize slippage when hedging options with futures.

Volatility trade example[5] breakdown – delta hedged covered call 

  • This is an example of a market participant expressing a long volatility view with a delta neutral position. 
  • One of the motivations for this view could be that the trader expects volatility rising higher into 2025 due to further uncertainty in corporate earnings.
  • In this theoretical example, a hedge fund calls a volatility trading desk at a bank, requesting liquidity in the December 2024 S&P 500 Dividend Index options. 
  • The following option strategy is quoted: In the December 2025, 72.00 strike call that is delta hedged against the S&P 500 Annual Dividend December 2025 futures, which means the strategy is delta neutral. 
  • A listed, delta-neutral covered futures and options block trade can be more capital efficient as the futures and options on futures could provide margin offsets and relief to charges commonly levied on OTC transactions.

Long call (long delta) and short futures (short delta) – the resulting combination in the delta position being neutral. 

Delta of option = 45 

Current option volatility ~ 5% 

Exhibit 4: Theoretical trade example

9:42:50am 2.50 S&P Annual Dividend Index Futures SDAZ5 S 225   Fut 71.65
S&P Annual Dividend Options SDAZ5 B 500 72.00 Call 2.50

Source: CME Group

  • In Exhibit 4, the bank provides an offer to buy the client 225 lots of the 72.00 call options at $2.50 and hedged delta neutral with 500 contracts S&P 500 Dividend Index December 2025 futures. The parties agree to the transaction. 

  • Traders can also “block trade” a covered option spread, provided that each leg meets the block minimum threshold of 100 lots. 

Block trades on the covered call, options are centrally cleared, thus mitigating counterparty credit exposure and associated risks. Market participants should consult the contract specifications for additional details including block requirements and reporting information as they are subject to change.


Conclusions

  • S&P 500 Dividend Index futures and options provide market participants with excellent tools to hedge dividend uncertainty, transfer risk, express market views and isolate dividend exposure 

  • Market participants can now express views with a wide variety of options strategies, trade dividend index volatility directly as well as manage risks via delta hedged solutions.

  • Options strategy trading flexibility – execute transparently in the CLOB or as privately negotiated blocks, providing an alternative to the opaque OTC market.

  • ADV continues to form and develop in options on S&P 500 Annual Dividend Index futures to around 800 lots compared to the underlying futures of 4,000.

  • Finally, when managing portfolio risk, operational and capital efficiencies can benefit options traders regardless of risk tolerance.


References

[1} For further details please refer to the following https://www.cmegroup.com/articles/2024/equity-index-dividend-futures-a-primer.html.

[2] An outright option is typically bought and sold individually and not as a part of an option strategy. In other words, when a market participant trades the outright option, they do not place a second contract to hedge their option.

[3] Dividend uncertainty with Meta - earnings announced on 1 February 2024 that for the first-time it was to pay dividends. The impact and movements in the various dividend futures and options.  This was seen again when Alphabet’s earnings announcement on 25 April 2024 that it was to pay a dividend for the first time.

[4] For further details please refer to the following https://www.cmegroup.com/solutions/risk-management/margin-services.html.

[5] Examples cited are for illustration only and shall not be construed as investment recommendations or advice. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. Please refer to full disclaimers at the end of the commentary.


All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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