Options and Dividends | What You Need To Know
May 25, 2017
By: Sage Anderson
Dividends are payments made by companies to investors and in many ways reflect the very essence of capitalism. Companies that prosper reward investors by sharing profits.
For traditional investors, a nice dividend payment can be a method of increasing returns, or a way of producing income on investments.
However, the mechanics of dividend payments also affect options traders, and for this reason, it's important to be aware of the dividend landscape and potential risks.
Before launching into a broader discussion, here is a brief review of some important terms related to dividends:
Declaration Date: the date details of the dividend (amount and timing) are announced to the public
Record Date: the date an investor needs to own the stock in order to receive the dividend
Ex-Dividend Date: the date investors buying the stock will no longer receive the dividend
While the first two terms listed above are fairly straight-forward, the third (ex-dividend date) requires further explanation.
Because stock trades take three days to clear, the ex-dividend date usually falls two days prior to the record date. Investors that want to receive the dividend, therefore, need to purchase the stock prior to the ex-dividend date in order to receive the dividend.
At a high level, there are two important themes when talking about options dividend risk. The first relates to the stock price adjustment made in the market when a company pays a dividend.
A stock is adjusted down on the morning of the ex-dividend date by the amount of the dividend. So if stock XYZ is trading $40 and pays a $1 dividend with an ex-dividend date of September 1st, that means that all else being equal, stock XYZ will open trading at $39/share on the morning of September 1st.
Obviously, options prices are based on where a stock is currently trading and where it might trade in the future. That means, the price of the calls and puts in XYZ must account for this upcoming adjustment.
Now imagine that stock XYZ decides to raise or lower their dividend. That means that the expectations built into the pricing of stock XYZ's options may have been miscalculated, and could significantly alter the fair value of these options when the actual dividend amount is announced.
In general, if a dividend is higher than expected, put values will rise and call values will decline. The reverse will be true if a declared dividend is lower than expected.
This means that a high degree of vigilance is required when trading options in underlying securities that have a somewhat irregular (or unpredictable) dividend histories.
The second type of options dividend risk that traders need to be aware of relates to the risk of assignment.
When dividends are paid, companies pay the designated amount per/share to each shareholder. However, short positions present a somewhat unique problem as it relates to dividend payments.
To short a stock, an investor borrows the stock from the original owner and then sells the stock (short) on the open market to another investor (the second owner). However, the original owner of stock that lent his shares to the short seller retains his benefits of ownership. That means that the original shareholder is owed any dividends paid by the company.
Looking at the mechanics, the second investor on the open market that bought the shares from the short seller will receive the dividend from the company. However, the original investor must still be made whole on any dividend payment(s), which means the short seller now owes the original investor the dividend(s) out of his/her own pocket.
For short sellers of stock, hopefully, they have calculated the cost of paying the dividend into their overall profitability expectations when placing the original short bet.
Now consider possible effects on options traders.
There is one position a trader can hold in the options market that forces one to get short stock - getting assigned on short calls. That means for sellers of calls, dividend risk is particularly elevated, because they may be forced into a position where they are obliged to pay a dividend.
For short calls, the main category potentially affected by dividends are in-the-money (ITM) options. This is because getting assigned on short calls that are out-of-the-money (OTM) is typically unlikely.
Regarding ITM calls, how might the owner of the call(s) decide if he/she wants to exercise their option(s) prior to the ex-dividend date?
Like anything in the trading world, this is a question of value. What's of greater value to the call owner, the "optionability" that comes with owning a long ITM call, or the dividend?
Traditionally, option traders decide this question by calculating the extrinsic value (time value) of the ITM call - they then compare that number to the expected dividend amount.
Extrinsic value, as a reminder, is everything that is not intrinsic value. And intrinsic value of an ITM option is the difference between the strike price and the market price of the underlying. So if stock XYZ is trading $42.15 that means the intrinsic value of the $40 calls is $2.15 ($42.15 - $40 = $2.15).
Now, imagine that the $40 calls are trading for $2.20 in the open market, which is $0.05 above the price of the intrinsic value. That means that the extrinsic value of the $40 call is $0.05 ($2.20 - $2.15 = $0.05).
The trader, therefore, knows the option they own has been given a time value of at least a nickel by the market. The next step is to check whether the potential value of receiving the dividend is higher than the extrinsic value of their option.
If stock XYZ is set to pay a dividend of greater than $0.05, the call owner would likely decide to exercise their contract(s) and receive the dividend, because that value is greater than the time value of the option they own. On the other hand, if the dividend payment is expected to be less than $0.05, the trader might prefer to hold his/her long option(s).
Traders that are short ITM calls can, therefore, check prior to the ex-dividend date whether or not the extrinsic value of the options they are short is less than the value of the dividend. If that is the case, there’s a good chance the trader will be assigned on those contracts and may want to close the position prior to the ex-dividend date.
To sum up, dividends are one of the important inputs that go into the computation of an option’s value. As a result, it’s important to monitor the amount and timing of dividends in underlyings that you trade.
Depending on your risk profile and unique approach, it may be prudent to avoid trading underlying securities with patterns of inconsistent dividend payout histories.
For further information relating to options dividend risk, we recommend reviewing the following:
As always, if you have any comments or questions related to options and dividends, we hope you’ll reach out directly at firstname.lastname@example.org, or leave a message in the space below.
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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