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Aug 3, 2015

Why Dividends Can Be Risky to Option Traders

By:Tom Preston

Last week a viewer sent me an article he saw about short verticals, dividends and profit and loss.  It was written by the Chief Investment Strategist at a mid-tier brokerage firm who had held big jobs at places like Peak 6 and O’Connor where they take option trading seriously. And it was wrong.

But the error was surprising only because it came from someone you’d think would understand it. How dividends impact option strategies can be confusing, and can lead to larger than expected losses. That’s what I aim to clear up in this article. With the right answer. Let’s look at the author’s example:

SPY was $212.88 and the dividend was $1.03. The night before expiration, which is also the ex-date for the dividend, the option prices were:

Call      Strike   Put

4.86     208      .08

1.86      211        .33

If you sell the 208/211 call spread (short the 208 call, long the 211 call) for 3.00 credit, what’s the max possible loss? The other guy says $401. Hmm…let’s see why. SPY goes ex-dividend (the date before which you need to buy the stock in order to be eligible to receive the dividend) on the options’ last day of trading. The night before SPY goes ex-dividend, the person who’s long the 208 call (you’re short that 208 call) exercises it to get long the SPY before the ex-div date, and be eligible to receive the $1.03 dividend. That makes you short SPY shares at $208 (the short call’s strike price) the next morning on the ex-date. 

On the ex-date, the SPY shares will be lower by the amount of the dividend, plus or minus some amount for normal market movement. He says $211.88. You lose $388 on the short SPY shares – you sold them at $208 and they’re now $211.88. The 211 call you’re long is now worth about .90 because it’s .88 in the money. If you sell that call you take in $90. So far, he says you’re down $388 and take in $90, which is a $298 loss. You’re also liable to pay that $1.03 dividend. So, he says the total loss is $298 plus $103 = $401. Wrong.

What’s he missing? 

Well, did you sell that 208/211 call spread for zero? Of course not! You took in $3.00 credit. If you apply that $300 against the $401 that you’d pay out to buy the SPY shares back and pay the dividend, the loss is closer to $101. 

If you sell the 208/211 call spread for $3.00 ahead of the ex-date, the max loss is $103. That’s because the max value the 208/211 call spread can be is $3.00 (the amount you sold it for), but you have to pay the dividend because of the assignment on the short 208 calls. To avoid paying the dividend, you’d exercise the long 211 calls the day before they go ex-dividend. That would create long SPY shares in your account that would offset the short SPY shares from the assignment. With no net short SPY shares in your account on the ex-date, you don’t have to pay the dividend. In that case, there’s no p/l outside of commissions.

Now, there are two problems that short in the money call spreads pose with regards to dividends. First, just because you short a call spread for a credit equal to the width of the strikes doesn’t mean that it’s a risk-free trade. If there’s an ex-dividend date before the expiration date of the options, you could be liable to pay the dividend. Second, the big problem with getting surprised by the dividend isn’t that the loss on one spread is so large, it’s that it’s possible to be able to do too many of these spreads in a small account. 

For example, the margin requirement on a short 208/211 call spread is $300. If you take in $300 credit, the credit covers the margin requirement. It’s possible to enter hundreds of such spreads in a small account, unless of course the broker has the technology to catch the risk of the upcoming dividend. The customer thinks there’s no risk to short the 208/211 call spread for $3.00, and doesn’t realize the possible $1.03 risk from the dividend. So, he does a hundred spreads in a $2,000 account, and ends up having to pay $10,300 in dividends. That’s the end of the account, and that customer. 

So, I appreciate the other author introducing the idea of additional potential risk to option strategies from dividends. I just wish he got the numbers right. But I guess that’s why you come to tastytrade.

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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