SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

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.

 

Related articles:

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Important Tips For First Time Currency Traders

    Diversifying your portfolio is important for all investors, and currency investments are a great way to do that. However, there are a lot of misconceptions and common mistakes that first time currency investors make, and this leads to big losses.

    By Kim,

    • 0 comments
    • 75 views
  • Iron Condors or Short Strangles?

    In my early option trading days, I favored selling iron condors over selling strangles. I thought that selling a strangle was too risky because the potential loss was “undefined”. I thought this made sense because this is what I’d hear from other people that were more experienced than I was.

    By Jesse,

    • 0 comments
    • 1,201 views
  • How To Be A Successful Day Trader From Home

    The good news is that if trading is your passion, then it’s possible to become a successful day trader and work from home. However, it’s not as easy as setting up shop and jumping online. There are specific steps and processes you need to have in place if you’re going to be able to make a living for yourself and have a bright career and future.

    By Kim,

    • 0 comments
    • 153 views
  • 3 Key Pieces Of Advice For New Traders

    These days, everyone claims to be an ‘expert’ on absolutely everything. Apparently, it only takes having a Twitter account to be a seasoned expert on any given subject; all in all, the Internet is full of nonsense. It’s becoming harder and harder to find legitimate answers amongst the quagmire of false information online.

    By Kim,

    • 0 comments
    • 215 views
  • Why New Traders Fail

    Our first advice to new traders is: "Learn First, Trade Later". The markets will always be there, but if you start trading without proper fundamentals, your capital will be gone very fast. The barrier to enter trading is so low today, commissions are near zero, and the whole trading game looks very promising.

    By Kim,

    • 0 comments
    • 411 views
  • Lumpy Dividends and Options

    Dividend payments, like oatmeal, may be smooth or lumpy. Smooth dividends are predictable, usually once per quarter. It is easy for options traders to believe these dividends are guaranteed, because they usually continue uninterrupted quarter after quarter. This also makes it easy to predict total return over a longer time span.

    By Michael C. Thomsett,

    • 0 comments
    • 384 views
  • Coming to Peace With Market Volatility: Part II

    On April 18th I wrote part I of this article, Coming to Peace With Market Volatility. I showed how the US equity market risk premium, defined as the annual average return of the Total Market minus the return of one-month US Treasury Bills, was a large 8.37% per year from 1950-2019. That’s the good news.

    By Jesse,

    • 0 comments
    • 421 views
  • Ratio Calendar Spreads

    The ratio calendar spread is well-known to some, but for others the risk/reward aspects are not well understood. One way to cover a short position is to own 100 shares of the underlying stock. Another, more creative way is to sell a shorter-term expiration position and buy a longer-term position.

    By Michael C. Thomsett,

    • 0 comments
    • 831 views
  • Studies Vs. Real Trading

    "Who you gonna believe, me or your lying eyes?" Our members and readers know that buying pre earnings straddles has been one of our favorite strategies that produced consistent gains in the last 8 years with very low risk. Yet there is a significant number of studies showing that this strategy has a negative expectation. 

    By Kim,

    • 0 comments
    • 776 views
  • Should You Hedge or Diversify?

    Using the most popular S&P 500 ETF (SPY) to represent the US stock market, this article will look at different ways to manage equity market risk using historical ETF and options data from ORATS Wheel since 2007. We will analyze the following unhedged, hedged and allocation choices:

    By Jesse,

    • 11 comments
    • 1,149 views

  Report Article

We want to hear from you!


There are no comments to display.



Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoji are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...

Options Trading Blogs Expertido