A dividend is a cash distribution, usually quarterly, to shareholders based on company profits. Investors that own the stock receive the dividend. Investors that are short the stock are required to pay the dividend. Dividends are non-events from a P/L basis. When dividends are paid, the stock price is reduced by the amount of the dividend so that no arbitrage opportunity exists. With that said, it is still important to know when a dividend is coming out, to see if your option position is at risk.
When it comes to dividends, in the money short call options are the only options that are at risk of additional early assignment. In some cases, the opposing party may exercise their option early to receive the dividend. Long call owners must exercise their option to own the shares prior to the ex-dividend date to receive the dividend. A simple calculation can be used to determine if you are at risk of early assignment or not:
If extrinsic value of the ITM short call is less than the dividend, the option is at risk of being assigned.
When short an option, we have to think about it from the long option perspective. When a long option is exercised, extrinsic value is given up as the call turns into long shares of stock. Stock has no extrinsic value. If the dividend is $0.25 per share, and there is only $0.10 of extrinsic value in the call, the owner is willing to give up that $0.10 to get $0.25 for the dividend, which results in a net cash gain of $0.15 per share.
If extrinsic value is greater than the dividend, it doesn’t make sense for the call owner to exercise, as they would be losing money in that situation.
So what can we do to avoid risk? If our ITM short call has less extrinsic value than the dividend, we can close the position altogether, or we can roll out in time to add extrinsic value to the call. Closing the position will eliminate all risk, where rolling to a further out cycle will add extrinsic value, and eliminate dividend risk if we add enough extrinsic value to outweigh the value of the dividend.
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