Below we’ll discuss both what happens to option contract holders when dividends are paid and how dividends impact option pricing.
Dividend Risk to Option Contract Holders
First, option contracts don’t pay dividends. If you own a call or put on a stock, and that stock declares a dividend, you do not have any right to that dividend until you own the stock. Of course, that does not mean the declaration of a dividend won’t impact your option contract.
Just as with stocks, there are three important dividend dates that effect option contract owners:
- Declaration Date: the date the details of the dividend are announced (price and what the important dates are);
- 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.
Because stock trades normally take three days to clear, the ex-dividend date usually falls two days prior to the record date. Investors who want the dividend must purchase the stock prior to the ex-dividend date.
If you don’t have any rights to the dividend, then why should option contract holders be concerned about them? As discussed below, it impacts option pricing, but the bigger potential impact for investors is “dividend assignment risk.”
Dividend assignment risk is the risk that you will be assigned an option because the other party to the option contract wishes to collect the dividend. Let’s take a simple example:
- Stock ABC is trading at $100;
- You sell the $100 call on ABC that expires this coming Friday for $1;
- On Friday ABC is worth $98.
Typically, your option would expire worthless, and you keep the dollar. However, what if ABC surprised everyone Monday afternoon and announced that ABC was declaring a special dividend of $5, with the ex-dividend date being Thursday? At this point, risk of assignment has gone through the roof – particularly if ABC is a low volatility stock. If ABC is trading anywhere north of $95 on Wednesday, the risk of assignment is pretty high. Notice the assignment risk is on the day before the ex-dividend day. Because of option clearing times, to be entitled to the dividend, an option holder must exercise the day before the ex-dividend date.
Note: on surprise dividend announcements, you may benefit from a dividend assignment – particularly if the stock price has declined. This is because your short call will be exercised at the strike price, and you can sell it back for less. Using ABC as an example:
- On Thursday, ABC is $98, and it is ex-dividend day;
- You get assigned 100 short shares of ABC and receive $10,000;
- You buy back the 100 shares of ABC for $98, making $200 plus the $100 option premium.
But for the option dividend surprise announcement, you would not have been assigned and only made $100.
The converse is true as well. Instead of being short the call, if you were long the call, when you decide to exercise is impacted by the dividend amount and the ex-dividend date.
If you are short a put, the risk of assignment because of a dividend is virtually zero. Why would an option contract holder assign you stock so YOU can receive the dividend instead of the option contract owner? The only way this would happen is if the price had declined for some reason other than the dividend making it an attractive exercise. But in that case, the assignment is occurring because of market forces pushing the stock price down – not because of the dividend.
Of course, it’s not really all this simple – because option pricing is impacted by dividends – whether regular quarterly dividends or surprise dividends.
Dividend Impact on Option Pricing
When a stock goes ex-dividend, its price is adjusted by the amount of the dividend. For instance, if stock ABC was trading at $100 on ex-dividend day and still was paying a $5.00 dividend, at the market open, ABC would open for $95.
On a side note, this is why buying stocks to receive the dividend then selling the stocks is a dumb strategy. A dividend does not increase your returns on the stock. Yet there is always a proliferation of “dividend paying” stock strategies.
Many have a problem understanding why this fact is true. But think of it in terms of what a stock price really is – it’s nothing more than a percentage what the company is worth at that moment in time. “Worth” includes all assets, intellectual property, liabilities, and so forth. This includes all of the cash the company has in the bank. If and when the company pays that cash out to investors, that cash is gone – representing a reduction in company value because it doesn’t have the cash anymore. So, once a dividend goes ex-dividend, the value of the stock goes down by that much. This does not affect the stock owner, since as the stock value goes down, they receive cash equal to that amount – net no change.
This is why when evaluating stocks, one should ask “how much is this stock going to appreciate” not “what dividends does this company pay.” Would you rather have a stock that goes up by 10% per year or a stock that goes up by 5% per year but pays a 4% dividend? (Hint: it’s not the dividend paying stock).
But because the stock price gets adjusted, that means option prices must get adjusted too. Otherwise everyone and his dog would buy puts on stocks right before they go ex-dividend, since the price is KNOWN to being going down. To prevent this, option prices are “adjusted” to accommodate an upcoming ex-dividend date weeks prior to that date so that no unusual gains or losses are experienced by option traders. Call options see a decline in their extrinsic value and put options see a rise in their extrinsic value.
What about the situation from above concerning special dividends that can’t be priced in a quarter or more in advance? Well, there are special rules for these situations. But what options traders need to know is that if the special dividend is more than $0.125 per share, special adjustments are made to the option strikes. You have may have seen the result of this on your trade screen when it appears as if there are “two sets” of options for the same strike and that expire on the same date. Option prices also get adjusted on stock splits, stock dividends (shares not cash), take overs, mergers and business splits.
The amount of the adjustment depends on the type of option contract and the event occurring. But the market makers ensure no option contract owner is getting a free lunch because of a special event.
Christopher Welsh is a licensed investment advisor and president of LorintineCapital, LP. He provides investment advice to clients all over the United States and around the world. Christopher has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Christopher has a J.D. from the SMU Dedman School of Law, a Bachelor of Science in Computer Science, and a Bachelor of Science in Economics. Christopher is a regular contributor to the Steady Options Anchor Trades and Lorintine CapitalBlog.