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The Effect of Dividends on Options Pricing


The theory of dividends and underlying stock prices is simple: The underlying price is expected to decline on ex-dividend date, by the amount of the dividend. As a result, option prices should decline as well. Under this theory, calls for higher dividend stocks should be valued lower and puts should be valued higher.

            The only problem is that this theory does not always work out. The anticipated changes on ex-dividend date fail to materialize more often than they do, for several reasons. To begin, an explanation of ex-dividend date is important. The use of “ex” means “without,” so that whether you earn a dividend or not depends on when you are the stockholder of record. If you have placed an order before ex-dividend date (at least three days before), and you do not close the position before ex-dividend date, you will earn the dividend. If you buy shares on ex-dividend date, you will not earn the quarterly dividend.
 

            This means you could buy shares before, and sell on ex-dividend date, and earn the dividend even with only a one-day holding period. This leads to a popular “dividend capture” strategy based on getting the dividend and moving in and out of the underlying. Hut what about that theory that the underlying price is adjusted by the amount of the dividend? This should mean that dividend capture does not work. But it does, and there are too many forces at work affecting option prices to make the simple difference in valuation that the theory calls for.
 

            The many reasons for this may represent a paradox. If option pricing were to be based solely on timing of the dividend, it would be simple. But options are priced on the assumption that exercise usually occurs on the last trading day, which is the third Friday of expiration month. How far away is expiration month? The answer will have more impact on option valuation than the dividend. The closer expiration, the greater the decline in time value, so the value of options is going to vary with the time factor and the resulting time decay.
 

            The understanding that underlying value falls on ex-dividend date, and that premium on options reacts in the same way, is further affected by the moneyness of the option. It should be assumed that the direct cause and effect of dividends applies to ATM options for the most part, and equally to ITM positions. The OTM option is less likely to be affected, especially if expiration is further away.
 

            Dividend yield is another factor to consider. Analysis of dividend capture shows that profitability often is marginal at best. If you buy an ATM call and exercise it the day before ex-dividend date, time value will determine whether it will be profitable or not. Most traders using dividend capture prefer buying calls expiring as soon as possible after ex-dividend date. But a decisive factor in this strategy is the dollar value of the dividend. The yield of the dividend should be high enough to surpass the value of the long call.
 

            This sounds simple. The idea is to buy the call and exercise it right before ex-dividend date, and then sell the shares on or after ex-dividend. But for this to work, the share price must be at or higher than the exercise price of the call, and there are no guarantees of this. In many instances, dividend capture yields a net loss or only marginal profits. It might work best for those holding shares for a longer term, if those shares have appreciated in value since purchase. Selling shares on or after ex-dividend date thus yields a profit, even if shares have been held less than a full quarter.
 

            Emphasis is usually on call premium values at the point dividends are earned. However, put premium also will be affected. They are likely to becomes more expensive considering the expected drop in the underlying price. Opening a long call and a long put at the same time, in a synthetic position, could offset a decline in put premium. But this is an expensive trade, so you would need a complex combination of factors to make the long straddle profitable: Attractive dividend yield, exercise of a long call with a capital gain in the underlying, and/or the long put to hedge any price decline. This complex adjustment clearly would not work in the short term, and the perfect price movement is not a guarantee.
 

            In other words, the dividend capture does not always work out, and any attempt to hedge against market movement could make the strategy unworkable. This is made more complex by the fact that you must be the shareholder of record the day before ex-dividend, meaning the trade must be entered at least two days before. Otherwise, the dividend is not earned. It is not possible to do a two-day turnaround and earn the quarterly dividend.
 

            It could be that just buying puts before ex-dividend, and then selling once the underlying price declines, is a practical alternative trade. But this works only if (a) the underlying price drops as expected and (b) the put’s premium exceeds any decline in time value and trading fees, so it could be closed at a profit.
 

            An evaluation of how underlying prices act based on dividends reveals something worth remembering: The stock and option prices usually react very little, if at all, to the timing of dividend record and earnings times. You are likely to see a zero effect on stock and option value due to the timing of a quarterly dividend. This contradicts the common belief that there is a direct and unavoidable cause and effect. If that were true, everyone would buy puts right before ex-dividend, and then sell and take their profits.
 

            What makes more sense than trying to beat the market based on dividend timing? Buy stocks with a long-term record of increasing dividends per share and dividend yield; hold for the long-term; and trade conservative options (covered calls, uncovered puts, and covered straddles, for example). Avoid strategies based on the belief that the market can be beaten with dividend capture and revert to the tried-and-true of smart value investing and conservative options trades. It works, whereas trying to beat the market does not.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

 

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