Stock Dividends and Option Strategies

Stock Options Strategies and Dividends

"Many investors are unaware of the facts regarding stock dividends. On the ex-dividend date, the stock price is adjusted downward by the amount of the dividend..."

This article is a supplement to; "Horses for courses' - married puts, or calls?".

You can read that article by clicking HERE (Married puts vs Call options)

Ex-dividend date.

This is really the only date an investor need be concerned about regarding eligibility for a dividend. If you own the stock at close of business the day BEFORE an ex-dividend date then you will be eligible to receive that dividend. On ex-dividend day itself, you could sell the stock and still receive the dividend.

In a nutshell; Ex-dividend day is the FIRST day that the stock trades WITHOUT the dividend.

Price Implications of a dividend on stock price.

On the ex-dividend date, the stock price is adjusted downward by the amount of the dividend. The reason for this is that the cash paid out in dividends no longer belongs to the company and this is reflected by a reduction in the company's market cap. The cash is gone from the company's valuation and the stock price is adjusted to reflect this. Sadly, a fact often misunderstood by investors is that a dividend represents absolutely no financial gain to an investor unless the stock price recovers this adjustment at some point in the future. For example....

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An investor buys 100 shares of stock X at a price of $50/share; $5,000 invested.

The company declares a $2 dividend with an ex-dividend date of January 10th.

At close of business on the 9th of January (the day before the ex-dividend date) stock X closes at exactly $50. The investor has $5,000 of value in his stock.

The next day, stock X opens at $48 due to the $2 downward adjustment of the stock price. The investor now has $4,800 value in the stock, plus $200 cash to come from the dividend. A total of $5,000, so no gain at this point in time, despite being eligible for a $2 dividend.

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It should be noted that the adjustment made on ex-dividend day rarely presents itself in the stock price so neatly as the usual shenanigans of pre-market activity also moves the stock price around. In the example above, if the market were bullish, then the stock might actually open at close to $50 or even higher. Nonetheless, a $2 adjustment has been made to the stock price, even if this is not immediately apparent amidst the general trading volatility.

Myth - Short-sellers must 'pay' the dividend

Well, technically this is true. However, contrary to most investor's assumptions, the short-sellers do not receive a financial 'kicking' for staying short through an ex-dividend day. In fact, quite the opposite is true as the adjustment down of the stock price to account for the dividend gives them an immediate increase in their account value (they make money as the stock price falls), yet the cash for the dividend is not deducted from their account until some time later. The long investor, however, suffers the indignity of a downward price adjustment and then must wait to receive that amount back in cash sometime later.

How does this affect put options?

Options are, basically, a 'derivative' of the stock price and play no part in the actual dividend itself. However, the adjustment of the stock price is reflected in the price of the options. Using the previous example; if the $2 dividend were a sudden, surprise announcement, the price of put options would increase in anticipation of the $2 drop to come in the stock price on ex-dividend day. This is not 'official' but a product of market participants (you, me, and the man next door) reviewing the value of those put options in light of new information. As a previously unexpected $2 drop is going to occur in the stock price, then $2 or so is likely to pile into the price of put options. (The additional value, provided by a surprise dividend, to any particular put option will depend upon how far 'In The Money' - above the current stock price - it is).

However, in the case of large dividend payouts which constitute 10% of the stock price or more, a special group meets and decides how to handle options on the stock. Most often, they decide to reset the stock option STRIKE prices in order to keep the strikes relatively close to the appropriate stock price following the ex-dividend date.

>Please note that some charting software and sources adjust their charts for dividends, some do not. It is important to know whether a chart is adjusted for dividends or not. Also note that most brokers will adjust any limit orders to account for the anticipated dividend adjustment. This prevents orders being triggered by the dividend adjustment without any other price fluctuation on the stock price.

IMPORTANT - if you have a 'collar position', which is a married put position with covered calls against it, in the event that the stock is called away, the put options will remain in your account and are not affected. It is, therefore, important that you quickly decide what to do as the put options would lose value if the underlying price rose sharply yet there would be no stock on 'the other side of the trade' to compensate for this.

Of course, one might get a sudden, unexpected bonus too, if the underlying price 'fell off a cliff' on ex-dividend day and you had put options sitting idle and unencumbered to take advantage of this. Much depends upon the amount of premium remaining in the put options at the time your stock was called away. If the premium were negligible, then it is often worth letting the put options 'ride it out' to see what happens, but the important point remains that the puts are not affected by the exercise of the covered call options.

What happens to long call options due to a dividend announcement

A surprise dividend, such as mentioned above, which boosted the price of put options in anticipation of the ex-dividend date adjustment, will have a negative effect on the price of call options as call holders are not eligible to receive the dividend. This, of course, makes the call options slightly less attractive and premiums will tend to deflate accordingly to incorporate the dividend information.

An individual investor, holding calls which are 'In The Money' approaching the ex-dividend day, must decide whether or not to exercise his calls for stock in order to claim the dividend. In doing so, of course, any remaining premium in the price of the call options would be lost.

As an alternative to exercise, the call-holder could, of course, sell his calls to pocket the remaining premium, then buy the stock and receive the dividend. However, this negates the risk protection offered by call options, and the price movement of the stock as traders anticipate implications of the dividend will greatly affect the benefits of exercising to stock.

Call options which are 'Out Of The Money' will not require much hand-wringing as there is no point in exercising a call option at a higher price than the stock is currently trading. Their premium will, however, be affected in varying degrees by the 'loss of opportunity' to participate in the dividend.

What happens to covered calls when a dividend comes along?

If you own stock and have sold a covered call against it, (also known as 'writing' calls against your stock), then you have given the holder of that call option the right to insist that you sell your stock to them at the strike price of the call option. In other words, exercise of the option is entirely at the discretion of the option holder.

Generally speaking, if an option is in-the-money (strike price is lower than the current stock price) AND the dividend value is greater than the outstanding premium remaining in the call options, then it would make sense for the option holder to exercise the call options and your stock would be transferred at the strike price. Any remaining premium, however, is yours to keep so the news is not all bad on losing stock to an exercise request because of a dividend. One further comfort is that there is nothing to prevent you from buying the stock back ex-dividend and receiving a rough equivalent to the dividend amount in the form of a 'discount', courtesy of the ex-dividend adjustment I mentioned earlier. I'd like to present an idealised example to demonstrate this in practice:

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Let's assume that you had purchased stock at $50 and sold the $50 strike calls for $2, of which 20c is remaining.

A $1 dividend is declared and, by an amazing coincidence only ever seen in examples such as this, the stock closes at $50.20 the day before ex-dividend.

(Often stock transfers are made after the market closes so your stock might not 'disappear' during market hours. It depends upon the broker)

The holder of the call option you sold hasn't achieved a great result so far, but only had $2 tied up in order to participate, and now has the opportunity to get stock which is paying a $1 dividend. Let's say that he decides to exercise the option and take your stock in order to claim the dividend......

You paid $5,000 for 100 stock, less the $200 received for the call option so your cost-base is $4,800 (The holder forfeits the 20c premium remaining as the agreement is to pay the $50 strike price value - the option's remaining premium of 20c is yours.

You 'sold' the stock for $5,000 - the $50 strike price of the call option which was exercised x 100 stock and so have a $200 profit so far.

Next day, the stock opens at $49.20 (again, this is a 'perfect example' where the div adjustment is exactly the dividend amount) and you can buy the 100 shares back for $4,920

End result - you still have 100 shares of stock but also have $280 in cash, comprised of: $200 from the covered call premium, plus $80 saved from buying the stock back 80c cheaper than you 'sold' it.