tastytrade logo
uploaded image

May 25, 2017

Options and Dividends: What To Know

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.

Dividend Risk

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.

Options DIvidend Risk

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:

Dividends: Avoid Unnecessary Assignment

Why Dividends Can Be Risky to Option Traders

As always, if you have any comments or questions related to options and dividends, we hope you’ll reach out directly at support@tastytrade.com, 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.

Related Posts

tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com. 

tastytrade is a trademark/servicemark owned by tastytrade.

tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).

tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.

Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.

© copyright 2013 – 2022 tastytrade. All Rights Reserved. Applicable portions of the Terms of use on tastytrade.com apply. Reproduction, adaptation, distribution, public display, exhibition for profit, or storage in any electronic storage media in whole or in part is prohibited under penalty of law, provided that you may download tastytrade’s podcasts as necessary to view for personal use.