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By Mark Wolfinger
Looking at a common situation, suppose that you have written a covered call. You owned 300 shares of YFS (Your Favorite Stock Inc.), watched it rally, and finally decided that it’s time to sell the shares because you believe they are fully priced at $41 per share.
Instead of selling the shares outright, you decided to milk this trade for additional profits and wrote three YFS March 40 Calls, collecting a premium of $2.50. If the stock is above $40 when expiration arrives, you will sell the shares at $40. Adding the option premium, your net is $42.50 instead of $41. Sure, there’s some downside risk prior to expiration, but you decide to accept that risk.
All goes well, the stock rallies further and when it’s trading at $44, you are surprised to be assigned an exercise notice because it’s one week before expiration. There was no reason for the option owner to exercise and the stock did not go ex-dividend. Nevertheless, you sold your stock, earned your profit and even collected the cash one week early. This is all good.
In most cases that’s the end of the story. However, on this occasion you learn the importance of not exercising an option earlier than necessary. On Monday and Tuesday of expiration week, overseas markets tumbled and the U.S. market followed suit. On top of that, YFS issues some minor news that, under ordinary market conditions, would have been shrugged off. However, with the nervous market and a substantial two-day decline, YFS fell out of bed. When the market opened Wednesday morning, it was trading south of $37 per share.
If you had not been assigned early, you would own stock and have no chance to sell at $40. So give a big “thank you” to the person who made the terrible decision to exercise.
Think of it this way — it’s exactly the same as if the person who exercised your calls said to you:
“Here is a FREE put option. I’m taking your stock now and in its place you now own three March 40 YFS put options. If the stock trades below $40 next week, you will have the right to sell those shares at $40. In reality you already sold the shares, but because most stockholders were not assigned an exercise notice, I’ve given you a special gift: three put options. I did this because I am certain these puts are worthless, but they are yours with my compliments.”
Of course, the exerciser does not truly think that way or else he/she would have never exercised early. This time you were saved from taking a loss. If YFS dips low enough that you want to repurchase the shares, you are in position to do so. If you still owned the original shares, you would not have the ready cash to make that choice.
Being assigned on a call option is the same as being handed a free put. Being assigned early on a put option is equivalent to being handed a free call. These “imaginary, free” options have the same strike and expiration date as the real options on which you were assigned.
Don’t be unhappy when assigned. It can be a rare gift.
Like this article? Visit our Options Education Center and Options Trading Blog for more.
Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
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Everything You Need To Know About Options Assignment Risk Can Options Assignment Cause Margin Call? Assignment Risks To Avoid The Right To Exercise An Option? Options Expiration: 6 Things To Know Early Exercise: Call Options Expiration Surprises To Avoid Assignment And Exercise: The Mental Block Should You Close Short Options On Expiration Friday? Fear Of Options Assignment
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By Pat Crawley
But in this article, we're going to show you why early assignment is a vastly overblown fear, why it's not the end of the world, and what to do if it does occur.
What is Assignment in Options Trading?
Do you remember reading beginner options books or articles that said, "an option gives the buyer the right, but not the obligation, to buy/sell a stock at a specified price and date?" Well, it's accurate, but only for the buy side of the contract.
The seller of an option is actually obligated to buy or sell should the buyer choose to exercise their contract. So when options, assignment is when you, the lucky seller of an options contract, get chosen to make good on your obligation to buy or sell the underlying asset.
Let's say you sold a call option on a stock with a strike price of $50, which you held until expiration. At expiration, the stock trades at $55, meaning it's automatically exercised by the buyer. In this case, you are forced to sell the buyer 100 shares at $50 per share.
So when selling options, assignment is when you, the lucky seller of an options contract, get chosen to make good on your obligation to buy or sell the underlying asset.
What is Early Assignment in Options Trading?
Early assignment is when the buyer of an options contract that you're short decides to exercise the option before the expiration and begins the assignment process.
Many beginning traders count early assignments as one of their biggest trading fears. Many traders' fear of early assignment stems from their lack of understanding of the process. Still, it's typically not something to worry about, and we'll show you why in this article. But first, let's look at an example of how the process works.
For instance, say we collect $1 in premium to short a 30-day put option on XYZ with a strike price of $45 while the underlying is trading at $50. Fast forward, and it's the morning of expiration day. Options will expire at the close of trading in a few hours. The underlying stock is hovering around $44.85. Our plan pretty much worked as planned until, for some reason, the holder of the option exercises the option. We're confused and don't know what's going on.
It works exactly the same way as ordinary options settlement. You fulfill your end of the bargain. As the seller of a put option, you sold the right to sell XYZ at $45. The option buyer exercised that right and sold his shares to you at $45 per share.
And now, let's break down what happened in this transaction:
You collected $1 in premium when opening the contract
The buyer of the option exercises his right to sell at $45 per share.
You’re now long 100 shares of XYZ that you paid $45 for, and you sell them at the market price of $44.80 per share, realizing a $0.20 per share loss.
Your profit on the transaction is $0.80 because you pocketed $1 from the initial sale of the option but lost $0.20 from selling the 100 shares from assignment at a loss.
Why Early Assignment is Nothing to Fear
Many beginning traders count early assignments as one of their biggest trading fears; on some level, it makes sense. As the seller of an option, you're accepting the burden of a legitimate obligation to your counterparty in exchange for a premium. You're giving up control, and the early assignment shoe can, on paper, drop at any time.
Exercising Options Early Burns Money
People rarely exercise options early because it simply doesn't make financial sense. By exercising an option, you're only capturing the option's intrinsic value and entirely forfeiting the extrinsic value to the option seller. There's seldom a reason to do this.
Let's put ourselves in the buyer's shoes. For instance, we pay $5 for a 30-day call with a strike price of $100 while the underlying is trading at $102. The call has $2 in intrinsic value, meaning our call is in-the-money by $2, which would be our profit if the option expired today.
The other $3 of the option price is extrinsic value. This is the value of time, volatility, and convexity. By exercising early, the buyer of an option is burning that $3 of extrinsic value just to lock in the $2 profit.
A much better alternative would be to sell the option and go and buy 100 shares of the stock in the open market.
Viewed in this light, an option seller can’t be blamed for looking at early assignment as a good thing, as they get to lock in their premium as profit.
Your Risk Doesn’t Change
One of the biggest worries about early assignment is that being assigned will somehow open the trader up to additional risk. For instance, if you’re assigned on a short call position, you’ll end up holding a short position in the underlying stock.
However, let me prove that the maximum risk in your positions stays the same due to early assignment.
How Early Assignment Doesn’t Change Your Position’s Maximum Risk
Perhaps you collect $2.00 in premium for shorting an ABC $50/$55 bear call spread. In other words, we're short the $50 call for a credit of $2.50 and long the $55 call, paying a debit of $0.50.
Before considering early assignment, let's determine our maximum risk on this call spread. The maximum risk for a bear call spread is the difference between the strike minus the net credit you receive. In this case, the difference between the strikes is $5, and we collect a net credit of $2, making our maximum risk on the position $3 or $300.
You wake up one morning with the underlying trading at $58 to find that the counterparty of your short $50 call has exercised its option, giving them the right to buy the underlying stock at $50 per share.
You'd end up short due to being forced to sell the buyer shares at $50. So you're short 100 shares of ABC with a cost basis of $50 per share. On that position, your P&L is -$800, the P&L on a $55 long call is +$250, on account of you paying $0.50, and the call being $3.00 in-the-money. And finally, because the option holder exercised early, you get to keep the entire credit you collected to sell the $50 call, so you've collected +$250.
So your P&L is $300. You've reached your max loss. Let's get extreme here. Suppose the price of the underlying runs to $100. Here are the P&Ls for each leg of the trade:
Short stock: -$5,000
Long call: +$4,450
Net credit received from exercised short option: +$250
5,000 - (4,450 + 250) = $300
While dealing with early assignments might be a hassle, it doesn’t open a trader up to additional risk they didn’t sign up for.
Margin Calls Usually Aren’t The End of the World
Getting a margin call due to early assignment isn't the end of the world. Believe it or not, stock brokerages have been around for a long time. They have seen early assignments many times before, and they have protocols for it.
Think about it intuitively, your broker allowed you to open the short option position knowing that the capital in your account could not cover an early assignment. Still, they let you make the trade anyways.
So what happens when you get an early assignment that you can’t cover? Your broker issues you a margin call. Once you’re in violation of their margin rules, they pretty much have carte blanche to handle the situation as they wish, including liquidating the assigned stock position at their will.
However, most brokers will give you some time to react to the situation and either decide to deposit more capital, liquidate the position on your own, or exercise offsetting options to fulfill the margin call in the case of an option spread.
Even though a margin call isn't fun, remember that the overall risk of your position doesn't change due to an early assignment, and it's typically not a momentous event to deal with. You probably just have to liquidate the trade.
When Early Assignment Might Occur?
Dividend Capture
One of the few times it might make sense for a trader to exercise an option early is when he's holding a call that is deep in-the-money, and there's an upcoming ex-dividend date.
Because deep ITM calls have very little extrinsic value (because their deltas are so high), any negligible extrinsic value is often outweighed by the value of an upcoming dividend payment, so it makes sense to exercise and collect the dividend.
Deep In-The-Money Options Near Expiration
While it's important to emphasize that the risk of early assignment is very low in most cases, the likelihood does rise when you're dealing with options with very little extrinsic value, like deep-in-the-money options. Although, even in those cases, the probabilities are pretty low.
However, an options trader that is trading to exploit market anomalies like the volatility risk premium, in which implied volatility tends to be overpriced, shouldn't even be trading deep-in-the-money options anyhow. Profitable option sellers tend to sell options with very little intrinsic value and tons of extrinsic value.
Bottom Line
Don't let the fear of early assignment discourage you from selling options. Far worse things when shorting options! While it's true that early assignment can occur, it's typically not a big deal.
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By Michael C. Thomsett
But dividends are not guaranteed. A corporation can suspend or cancel dividends anytime it wants. This inevitably affects the value of shares and, as a related matter, the premium value and return on options. This can occur for many reasons, such as unexpected losses, weak cash flow, or a desire by management to create cash reserves rather than sharing profits with stockholders.
For anyone intent on calculating option returns, the uncertainties of dividend policy complicate any calculation. The original Black-Scholes pricing model (the most often cited of all models) is deeply flawed for many reasons, one of which is that dividends are not even part of the calculation. It was assumed (probably just for simplicity) that no dividend was paid on the underlying stock, thus no dividend return was made part of the return. Today, though, traders know this is just unrealistic. Such a large portion of all listed companies include dividends that it cannot just be ignored or overlooked. Among the many later adjustments to the pricing formula, attempts have included adding in dividends, but this just sets up another variable among numerous existing variables. If the calculated dividends end up being lumpy, it makes any price formula that much harder to figure out.
This only adds to the problem of trying to tie down any pricing of options to a reliable and definitive result. This attempt to predict dividends using a continuous dividend model (one in which today’s dividend will continue into future payments at the same rate). Adding to the variability of this is the tendency for dividend yields to be raised or lowered over time. It is rare for a dividend yield to remain unchanged over an indefinite timeframe, so even based on a continuous dividend model, it is elusive to try and estimate future yields. Even so, the continuous approach used for companies whose dividends have been steady over many quarters, may be preferable to use rather than trying to calculate lumpy dividends.
The more the dividend yield and timing of payments changes, the lumpier the dividend yield becomes, especially if adjusted to an annualized basis. Smaller companies relying on cash flow from one period to another are most likely to change dividend yield frequently and may even suspend the quarterly dividend altogether. This tendency reals that
… younger firms with small capital tend to invest more in capital, and they withhold paying dividends. These firms initiate dividend payouts mainly to reduce the increasing cash holding and investment costs, as capital is accumulated. [Nam, Changwoo (August 2011). “Essays on a rational expectation model of dividend policy and stock returns.” Office of Graduate Studies, Texas A&M University, p. 2]
The only way to manage a lumpy dividend schedule is to estimate future dividend dates and payments based on the past. This introduces a likelihood of greater error into dividend and option pricing, but it may be the best alternative. Considering the uncertainty in the entire questions, it is not realistic to expect to develop a method for accurately figure out option pricing base don lumpy dividends … or for that matter, in any circumstances.
Like all calculations of return, even taking variables into account will not ensure better accuracy. The dividend yield, declaration per share, and timing of both ex-dividend and payment dates, all add uncertainty. But another consideration is whether absolute accuracy matters. Because options often remain open for only a short period of time, the calculation of dividends might not be as important as many traders think.
An alternative to detailed calculations could involve the following steps:
Calculate average annual dividend yield for the last three years (or five years). Based on whether the yield has been rising, falling, or remaining flat, next calculate a likely future annual dividend yield following approximately the same curve. Divide the estimate annual future dividend yield by the time remaining to last trading day or currently open dividends. This creates a return if the option remains open to the end of its life. (If you anticipate closing earlier, this may be built into the model for the same of fine-tuning the estimated option price. This method is as imperfect as any other model, but it introduces a somewhat systematic attribute to the calculation. It is also affected by whether the open option is simply closed, or if the underlying security is closed as well through exercise. This adds yet another variable to the entire question.
One last point about lumpy dividends: Whenever payments of dividends are non-uniform (lumpy), the chances of early exercise appear to be greater, and early exercise premium relies not only on the most recently paid dividend, but also on the timing of previous lumpy dividends over the life of the option. [Valkanov, Rossen et al (August 2005). “Does the early exercise premium contain information about future underlying returns?” UCSD, p. 2 - https://rady.ucsd.edu/faculty/directory/valkanov/pub/docs/early-exercise-premium.pdf]
This means that the current variability of lumpy dividends does not occur in isolation but is likely to be part of a trend. That trend includes a higher risk of early exercise. This itself may represent the most important aspect of lumpy dividends.
Michael C. Thomsett is a widely published author with over 90 business and investing books, including the best-selling Getting Started in Options, now out in its 10th edition with the revised title Options. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on Seeking Alpha, LinkedIn, Twitter and Facebook.
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3 Dividend Traps To Watch For Dividends And Options The Effect Of Dividends On Options Pricing What Options Traders Need To Know About Dividends Options: Debt And Net Return
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By cwelsh
Option assignments occur in two basic varieties. First, on expiration Friday (or Thursday or Wednsday depending on the instrument your trading, but most commonly on Friday). If you have a position that is .01 in the money, or more, you WILL be assigned. For instance, if you have a 100 Call on stock XYZ that expires today, and XYZ closes (AFTER HOURS) at 100.01, you will find that you own, sometime Saturday, 100 shares of XYZ that you paid $100/share for.
Now this option might have only cost you $100 or so. But all of a sudden, due to the inherent multiplier in options, you are now out of pocket $10,000.00. What if you're account only had $5,000.00 in it? Well, you are going to get both (a) a Regulation T Notice and (b) margin call from your broker. First thing Monday morning, your broker will automatically liquidate the position. What if there is adverse news over the weekend and the opening price is only $80? Well you just lost $2,000.0 -- in a $5,000.00 account. In other words, that $100 option just cost you 40% of your entire account. This happens.
What if you had "hedged" the position though, and had a vertical call spread? For instance, you might have bought the $100/$105 spread on XYZ. Well if XYZ closes anywhere above $105 you are ok because BOTH positions will be auto-exercised. This SOMETIMES results in a margin call as well -- but don't worry. Option clear throughout the day on Saturday and your account will frequently show one position and the other not exercised yet. By Sunday morning it will be fixed. By way of example, I had a very large position (for me) (20 contracts) in the LNKD 92.5/95 vertical call before earnings. Well earnings did what they were supposed to and LNKD jumped to 104. Well Saturday morning, all of a sudden, I was SHORT 2000 shares of LNKD and had received roughly $190K in cash into my account. This sends off all kinds of margin alerts. I got an email, a call, and another call. Ignore them, they're idiots. The 92.5 side simply hadn't cleared yet. Three hours later the other option cleared, buying the shorts back at 92.5. Then Sunday morning, your account statement will reflect that all trades happened at the same time.
HOWEVER, what if, on that 100/105 spread, XYZ closes at 103 on Friday? Well, guess what, you'll be assigned on the 100 position, the 105 will expire worthless, and now your back in margin call.
MORAL OF THE STORY:
DON'T EVER LET YOURSELF BE ASSIGNED ON A SPREAD THAT'S NOT FAR IN THE MONEY ON BOTH LEGS.
What if, on Friday, the price of XYZ was at $106 at close? You better have closed the spread, because of after hours trading. The price of XYZ can move after hours -- but you can't get out of the options. So if the market closes at 106, and you say good, both legs will clear and I won't pay commissions (or pay less commissions) and get a huge tax break, you could be wrong, as in after hours the market might go back to $104.98. Then you're screwed, only the 100 option gets exercised and you go into margin call. I'm convinced when your near a strike the market makers manipulate the after hours markets to have this happen.
Of course if you have enough cash in your account, you won't get margin called -- you're risk profile will just be largely out of whack.
And this isn't to say you can't have a big benefit from this. My single most profitable trade EVER occurred on a spread that was $.50 above the line, I didn't close it, and then in after hours the price dropped. So I got assigned long on the lower strike. Well, that weekend there was big news involving the company and the price jumped 15% the next morning. In that case, here's what happens -- I own the 100 (long) /105 (short) vertical. After hours, the price is $104.92. Well that spread was worth $4.85 at close on 20 contracts, or $9,700. Well, Saturday I'm now the proud owner of 2,000 shares bought at $100.00 each, for a net cost of $200,000 -- oops. Margin call, broker call, broker email, etc. Well they inform me the trade will immediately close at open on Monday. Well the price jumped, and the position was closed, at $240,000.00. My original investment of $8,500.00, that I didn't want to close at $9,700.00, netted me $40,000.00, or roughly a 470% return. BUT, what if the price had gone down 20%? Well I would be owing my broker money and have completely blown out my account.
If you have ANY questions on this, please let me know.
Now SITUATION TWO -- and you will, sooner or later, encounter this. Let's say we have that same 100(long)/105 (short) spread on XYZ. Only we own the September spread and today (Friday) XYZ closes at 103. No bigger. UNLESS someone exercises their 100 spread. American style options can be exercised at anytime. Why would this happen with time value? Who knows, most likely someone needed to unwind a position, hedge something, take profits, any number of things really.
Well if you had a 10 contract position, on Saturday your account is now down $100,000.00 in cash and you won 1,000 shares of XYZ. You will again go into margin call. However, while this is a headache and you will have to deal with your broker, you don't need to panic because the position is still hedged. You can certainly still lose money -- but only up to the 105 line.
What happens? Well your broker will force you to exit the position Monday morning at the open. If you BEG and wheedle, the broker might let you close the position yourself, so you can close at the midpoint instead of just a market order. They should let you do this because the position is still hedged, but you are technically in a Reg T violation, so they won't let you hold it for long. Monday you'll have to sell your shares and buy back the short calls. This should be, at worst, a break even situation because of the time value left in the short calls. However, markets fluctuate and you might have to sell your stock at something like 104 and by the time you exit the short calls its up to 105 (or you get a bad fill price) so you give back some.
When this happens, take your lumps and move on. I have this happen about once a quarter and my worse loss was 4%. There's nothing you can do to protect against this. You are hedged, and you won't blow your account out, but it does suck.
I hope that clears some things. If not, please let us know.
By Christopher B. Welsh
Christopher B. Welsh is a SteadyOptions contributor. He is a licensed investment advisor in the State of Texas and is the president of a small investment firm, Lorintine Capital, LP which is a general partner of two separate private funds. He offers investment advice to his clients, both in the law practice and outside of it. Chris is an active litigator and assists his clients with all aspects of their business, from start-up through closing.
Chris is managing the Anchor Trades portfolio.
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By cwelsh
It is not. (Well, it is rarely a problem). In fact, almost 99% of the time, early assignment is a better outcome. Below will set forth two common assignment examples, work through the potential outcomes, and demonstrate why assignment is typically a better outcome than having just held the position.
For Steady Option’s Anchor members, there is a persistent risk of being assigned a long stock position on the income producing portion of the strategy (the short SPY puts). This only happens in sharp market declines or very close to rolling of the position, but it can happen. Assignment risks increases the closer the position gets to a delta of 1. Most recently, this happened the week of May 13, 2019.For purposes of this example, we’ll use the actual SPY positions and walk through what did occur and could have occurred in other possible market situation.
In early May, the strategy sold four contracts of the May 20, 293 put for $3.11. The market started to drop. On May 19, 2019, the options were early exercised when SPY hit 285. The value of the contract when assigned was $8.11. All of a sudden, most accounts had 400 shares of SPY and were down $117,200 (4 contracts x 100 x $293). Most accounts don’t have cash in them to cover the position and may have received a Reg-T notice (a Reg-T notice is a form of a margin call by your broker). What is a trader to do?
Well first, the next trading day, simply close the position. Sell the stock, and the margin call should be covered. If it’s not, you can always sell other holdings to cover it. The way the Anchor Strategy is structured, it is virtually impossible not to have available cash or stock to cover in this situation. After closing the assigned position, is the trader worse or better off than if the position had been held? In all market conditions (up, down, flat), the trader is either in the same position as not having been assigned or better off.
Note: This assumption ignores transaction costs. Some accounts have assignment fees, different commissions for buying and selling stocks and options and other various fees. These fees could make a difference on the analysis, depending on a trader’s individual account. Since such fees vary widely, the below discussion ignores all fees.
The Market stays flat, SPY stays right at 285
In this case, the trader sells the assigned shares back at $285, facing a loss of $8.00/share. ($293 - $285)[1]. In other words, the trader has lost $1,956 ($8 stock loss less $3.11 received for selling the original position). This seems like a poor outcome.
[1] For purposes of this article, I am going to ignore the fact that the position was hedged and look at it just from the assignment point of view.
However, this is better than if the trader had just closed the short put at $8.11 at the market open. In that case, the trader would have lost $2,000. (($8.11 - $3.11) x 4 x 100). By being early assigned, the trader saved $0.11/share. This is what actually happened in actual trading the week of May 13.
The Market moves up the next morning
What would have happened though if the market had gone up? Let’s say to SPY $288. In this case, instead of selling the stock back at $285, you would sell it back at $288. That is a loss of $5 per share ($293 - $288) for a total loss of $756 on the trade ($5 - $3.11).
Once again, the trader is better off. Delta of the short put is not one, rather it had a dynamic average of .95. This means the value of the put would have declined not to $5.11 (the previous price of $8.11 - $5.11), but, by $2.85 to $5.26. Closing that option position would result in a loss of $860 on the trade ($5.26-$3.11).
The Market goes down
The scariest situation for a trader is waking up the next morning and the market has declined. Instead of SPY $285, the market might have continued to go down to SPY $282 (or worse). In this case, the trader sells the stock for $282, resulting in a loss of $11 per share for a total loss on the trade of $3,156 ($11-$3.11).
Yet again, the trader is better off. With the market going down from $285 to $282, the dynamic delta average is .98 and time value has dropped a bit, and the short put is now worth $11.03. Closing this put for a loss of $11.03 results in a total loss on the trade of $3,168. Even if the market had plunged down to SPY 100, the two positions would have been equivalent – meaning that the loss by being assigned equals the loss of having been in the short put.
In other words, in every market situation, the trader is either better off or exactly the same when assigned the position rather than having simply held the short put. The closer delta is to 1, the more likely you are to be assigned, but even in that situation, you would be no worse off between assignment and holding.
But if that’s true for puts, is it also true for calls?
Let’s take a common example. You sell 5 contracts of the $100 call on Stock ABC that is currently trading at $99 for $2.00. You are now short the $100 call. You receive $1,000. It expires in 3 weeks. Two weeks from now the stock is trading at $99.80 with earnings coming up tomorrow, and the option is trading at $1.00.You have $1,000 in cash and -$500 in call value. Someone exercises the option. The next morning your account looks like:
Short 500 shares ABC at a value of $49,900 Long $51,000 cash ($50,000 for sale of stock at $100/share plus $1,000 from the sale)
Are you in trouble? Did you lose money? Once again no, you’re not. Let’s look at what happens in each situation at market open:
The Market stays flat at $99.80
In this situation, you buy back the 500 shares of Stock ABC for $49,900. You keep the $51,000 and did not have to buy back the call. So you’re up $1,1000.
If you had not closed the position out, not been assigned, and the market stayed flat, the price of the option may have declined to around $0.50.
Clearly, you are better off because of the assignment – by over $800.
The Market goes down (any amount)
Earnings come out and the price drops to $90 (or any value below $100). In this situation, you buy back the 500 shares for $45,000. You keep the $51,000 and did not have to buy back the call. So you’re up $6,000.
If you had not closed the position out, not been assigned, and the market went down, the price of the option may have declined to $0.01.
Again, you are better off because of the assignment – by almost $6,000.
The Market goes up by less than $2 (to under $102)
Earnings come out, and the price increases to $102 (or anything between the last close and $102). You buy back the shares for $51,000. This nets out the cash you already had and did not have to buy back the calls. In this situation you break even.
If you had not closed the position out, not been assigned, and the market went up, the price of the option contract would have increased to at least $2.00.
In this case, you are in the same boat because of the assignment. Closing the short contract at $2.00 would cost you $1,000, which nets to $0.00 with the $1,000 you received from the sale.
The Market goes up by more than $2 (e.g. $110)
Earnings come out, and the price increases to $110. In this situation you must buy the shares back for $55,000. Offsetting with the cash already received, you have lost $4,000.
If you had not closed the position out, not been assigned, and the market went up a significant amount, the option price would have increased to at least $10. Closing this short contract out will cost $5,000. You are again better off because of the assignment.
In other words, in every situation you are in an equal or better situation because of an assignment. This is because options have time value – which an early assignment forfeits to the option contract holder. Even if the option contract had no time value left in it, the worst situation is still break even.
The only real risk to assignment is failing to quickly move and adjust the position (eliminate the oversized short position), your account goes into a Reg-T call, and your broker starts closing positions in a non-efficient manner.There are brokers who also require margin calls to be covered by cash deposits, instead of adjusting positions. (Very few). If that’s the case, you may get a demand for cash (and switch brokers).
As long as you stay on top of your positions and address any assignments, there is no reason to fear early assignment since in all situations you will be either equal or better off on early assignments. This is why I am almost always surprised by early assignments. The only time early assignment really ever makes sense is on surprise dividend announcements that weren’t originally calculated into the option prices – and even then, as the price of the option likely moved before the assignment occurred, there may be no impact.
What any option investor should always keep in mind is what to do if they get assigned early, what that will look like, and what trades will need to be entered the next business day. Being prepared prevents fear and mistakes – particularly when there is no need for that fear in the first place.
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 Strategy and Lorintine CapitalBlog.
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By cwelsh
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.
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By Michael C. Thomsett
If you use any strategies that combine equity positions with option hedges or cash generators, you need to know how to pick the right stocks. So covered calls, protective puts, covered straddles, and many more strategies should be opened on the best possible companies and their stocks.
Picking stock just for maximum yield (on both options and dividends) is unwise because it is likely to expose you to greater volatility and market risk. Options trading is not isolated from stock performance, and that grows from well-picked companies – meaning fundamentally strong, consistent, and competitive companies. Weak companies often reveal higher than average dividend yield and option premium, but not always for good reasons. These can be danger signals that every trader should know.
Dividend achievers and dividend aristocrats
Companies increasing dividend per share for `10 years or more are called dividend achievers; those increasing dividends consistently for 25 years or more are called dividend aristocrats.
These are important and distinguishing features for one reason: These companies with exceptional dividend record also tend to out-perform the market in the long term. Not all, but most, have demonstrated lower market risk and consistent returns in the stock prices, dividends, and options.
As a starting point, checking the status of dividends per share is a strong indicator. But it is not the exclusive test of whether a strong dividend record is enough.
Growing dividends and growing long-term debt
Dividend should always be understood in the context of how a company funds those dividends. You might have noticed that some companies report net losses in certain years but continue to raise dividends. Is this accomplished from cash reserves or from somewhere else?
Observing ever-higher dividends per share over many years is only half of the total equation. Also check the status of the debt-to-capitalization ratio. Total capitalization is the combination of long-term debt and stockholders’ equity. Dividing long-term debt by total capitalization reveals the percentage of total capitalization represented by debt.
If this ratio is increasing over several years, it is a red flag. The more a company relies on debt and the less on equity, the more future earnings will have to be used for debt service, and the less will be available for expansion and dividends.
Some companies take on increasing long-term debt to finance dividends when earnings are not high enough to do the job. As the ratio approaches 100%, equity shrinks to near zero. To see examples of where this leads, consider the recent history of one-time solid Blue Chips General Motors, Eastman Kodak and Sears. All of these saw their long-term debt outpace equity and cause bankruptcy.
When dividends increase but a corresponding increase in long-term debt occurs at the same time, those higher dividends are not positive signs. The dividend trend along with the long-term debt trend tells the real story.
The problem of higher dividends
Is a higher dividend always good news? No.
You need to evaluate the recent history of the stock price as well as dividends per share. If the share price falls many points, the dividend yield moves up and becomes a larger yield. For example, a $50 stock paying a $2 dividend yields 4%. If the stock falls to $40 per share, that $2 translates to a 5% yield.
A move from 4% to 5% looks pretty good at first glance. But why did the stock price fall 10 points?
If the most recent earnings report included a negative revenue or earnings surprise, that could be the cause for the loss of share price. If the company’s guidance is revised to forecast weaker future revenue and earnings, that also brings down the share price. In this situation, the dividend yield is not as positive as it appears at first glance.
The yield you earn is fixed
Some investors with equity positions in a company’s stock tend to track dividend yield often, even daily. This makes no sense.
The yield you earn is going to be based on what you paid for shares of stock. No matter whether the stock price rises or falls, the true yield is the dividend per share, divided by your basis and not by the current price.
The dividend trend is useful for determining whether to keep the position in your portfolio or to purchase additional shares for increased option hedging or cash generation. But your yield remains unchanged.
Dividend yield as a starting point in picking stocks
Options traders who also hold equity positions must decide which stocks to acquire for options trading. A popular method is to compare option yield based on premium value and time to expiration. This is not the best method for deciding which stocks to use for options trading; the higher premium often translates to higher volatility. Translation: Higher-yielding options premium equals higher market risk.
For some traders, that higher risk is acceptable. But for most, a consistent and reliable level of yield from options trading makes more sense. To pick the best stocks, use dividend yield to narrow down the list of candidates. You will find that if you select only those stocks yielding 4% or more, you end up with a very short list. When a test of the long-term debt trend is added, the list shrinks again. Adding in annual P/E range, revenue and earnings, the final list will come down to a very small number of companies, perhaps under 10.
The methods for picking options range from high-risk to extremely conservative. When it comes to dividends, widespread misconceptions cloud the decision. Many analysts continue to rely on the current yield as the primary test of how a company controls working capital. But combining dividend yield and long-term debt trends tells the real story.
Dividend trends tell a much larger story for options selection than most fundamental indicators. Picking the best option is a function of picking the best stock; and the combination of dividends and long-term debt reveals the long-term strength or weakness of the company’s policies.
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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By Michael C. Thomsett
Options traders may tend to think in the short term, but whether short-term or long-term, selection of the underlying should be based on sound fundamental signals; and dividends are not always positive for traders.
1. Basic math may cloak bad news
The math behind dividend yield can easily mislead traders, especially when there is bad news for the company. The lower the stock price, the higher the dividend yield, so in picking an underlying based on higher than average dividend yield, a little research can prevent a lot of pain.
For example, a pharmaceutical company has declared a dividend equal to 3%. The stock price is $80 and annual dividend is set at $2.40 (0.60 per quarter. This 3% yield is attractive, and at that level, buying stock and then employing options to hedge market risk or generate cash could make sense. But perhaps you are looking for high-yielding stocks for your options portfolio, so at 3%, you look elsewhere.
The following week, the company announces that drug trials did not go well, and the company has abandoned further research. The stock price declines to $62 per share. The day after that, another drug is rejected by the FDA and the stock price falls once again, to $48 per share.
All this bad news makes the company less attractive than ever, especially as management revises guidance for future profits due to these two instances of bad news. But at $48 per share, dividend yield is revised to 5% ($2.40 ÷ $48).
Even though the revised yield is the consequence of bad news, the stock now meets your criteria for purchase. You add the stock to your portfolio and begin writing covered calls. But was this a wise move? In fact, the future looks bleak for the company based on failed drug tests and FDA denial of approval. This points out the importance of thorough research beyond a single trigger. If your sole means for picking sticks is dividend yield of 5% or more, you might overlook the underlying cause and end up with poor portfolio holdings.
In this case, an “improved” dividend yield is the result of declining fundamentals.
2. High dividend trends place strain on future expansion.
There is considerable strain on management to increase dividend per share every year. The attractive attributes of dividend achievers or dividend aristocrats motivate management in some instances to keep increasing dividend, just to qualify for the designation of exceptional dividend growth. But is this always a positive matter?
Dividend per share should be increased when earnings per share is improving. In that case, giving more earnings to investors through dividends makes perfect sense, and makes the company more attractive as an investment. But what if earnings decline?
In this case, increasing the dividend per share means a higher percentage of net earnings are paid out in dividends. If EPS has declined, what does this mean? It means that a lower percentage of earnings remain as working capital to fund current obligations and to expand. Over time, the higher dividend payout ratio begins to harm working capital, which of course is negative.
For options trading, strain on working capital translates to lost market opportunity and a cut in budgets to maintain profitability. Ultimately, for options traders, this is also a negative. Higher volatility in the underlying adds market risk to both stock and option positions.
By increasing dividends even as EPS declines, management decides to reduce working capital. Unfortunately, many investors decide to ignore the relationship between dividend yield and dividends per share. Management, as well as investors, believes that higher dividends are always perceived as positive trends, but it is not always the case. An informed dividend policy should be based not on the need to increased dividends per share every year, but on the limitations of EPS.
3. High dividends could translate into growing long-term debt
The most destructive management policy involving dividends is to increase the dividend per share even when the company loses money. For those options traders watching the fundamentals, it might be puzzling that a company reports a net loss but continues to increase its dividends per share. Attaining dividend achiever status easily ignores a reality of how destructive this can be to future cash flow.
The most likely way that a company increases dividends in years when a net loss is reported, is by increasing the long-term debt through issue of new bonds or acquiring long-term notes. This higher long-term debt funds dividends and maintains the illusion of dividend-based success. It may also maintain a healthy appearance in current ratio, a common measurement of working capital (increasing the balance of current assets through acquiring more debt is easily done, but it does not truly mean working capital is improved).
There is nothing illegal about a company taking on more debt to maintain its record of increasing dividends. But is it ethical? A more responsible policy might be to reduce the dividend per share or even skip the dividend altogether. This would be more beneficial to stockholders in the long run, even if the immediate impression would be negative. A reduced dividend or a skipped dividend is seen as a sign of failure, but in a period of net losses, it could be the most responsible decision by management.
* * *
The dividend policies enacted by management should be motivated by long-term understanding of working capital and making tough decisions beneficial to stockholders. But the market culture tends to measure success blindly. Higher dividends, good. Lower dividends, bad. Unfortunately, the market pressure on management only promotes this thinking.
The solution for options traders: Avoid trading options in companies whose long-term debt continues rising each year. Check the debt-to-capitalization ratio to spot trouble in the debt and dividend trends. Seek companies matching dividend per share to earnings per share. That just makes more sense.
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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By Michael C. Thomsett
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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By Michael C. Thomsett
Too often, options are selected based on the immediate return of the option itself. This invites higher risks. Volatility is expensive, so you pay more for risky options (on risky stocks). Writing covered calls appears to offer higher profits due to this relationship; but in practice, when you accept higher risks in the underlying, you expose yourself to higher overall risk, both in the underlying long position and in the short covered call position.
A wise method for deciding which stocks to use for writing options, is to first quality a company based on strong fundamentals; and to then identify covered calls that offer better than average annualized returns. This usually means writing a series of short-term covered calls rather than a long-term series. Due to more rapid decline in time value, shorter-term covered calls are more profitable.
For example, in the final week of an option’s life (from Friday before expiration up to last trading day), an option will decline significantly in value. That Friday to the next trading day, Monday, options typically lose one-third of remaining time value. Short-term trading is highly profitable. Writing 52 one-week calls is more profitable than four 90-day calls or one 360-day call.
The money value of longer-term calls is higher, but there are two problems with selecting those contracts. First, you accept a longer time for exposure, meaning a greater change the call moves in the money and the underlying gets called away. Second, annualized return is better on one-week and two-week calls than on the longer-term alternatives.
Another way to test for quality stocks, which will be used for writing covered calls or uncovered puts, is to analyze the relationship between debt to total capitalization ratio, and net return. Total capitalization consists of long-term debt and stockholders’ equity. Dividing long-term debt by total capitalization produces this ratio. The higher the ratio, the more the company depends on debt capitalization. This means future profits will be less available to pay dividends or fund expansion. But how does this affect option pricing?
The option price is determined by historical volatility of the underlying; and the more danger in ratios like the debt ratio, the greater the market risk. A study of two companies with exceptionally high debt to total capitalization ratio is revealing:
Lockheed Martin (LMT)
Fiscal Year
Debt to total cap ratio
Net return
2018
81
9.4%
2017
100
3.9
2016
90
10.9
2015
78
8.9
2014
64
9.1
2013
56
6.6
2012
97
5.8
Source: CFRA Reports
Philip Morris (PM)
Fiscal Year
Debt to total cap ratio
Net return
2018
128
26.7%
2017
130
21.0
2016
142
26.1
2015
148
25.7
2014
148
25.2
2013
112
27.5
2012
84
28.0
Source: CFRA Reports
In both cases, changes in the debt ratio did not have any obvious relationship to the level of net return (net income divided by total revenue). A logical assumption would be that higher debt translates to higher net return, if the long-term debt is used to expand product and territory. But in this case, net return was not affected by higher debt.
However, dividend per share was affected. The LMT dividend moved from $4.15 per share in 2012 and was increased every year to $8.20 in fiscal 2018. The PM dividend also grew from $3.24 in 29012 up to $4.49 per share in 2018.
Although there is nothing illegal about using debt to pay higher dividends, it is not a wise use of working capital. It would make more sense to hold long-term debt at the same level and reduce dividends per share. But that would be unpopular.
Options traders may be aware of higher dividends per share and may even use this as a method for picking stocks to write covered calls or uncovered puts. But the choice is limited unless two other fundamental trends are also studied: long-term debt to total capitalization, and net return. There are a good number of companies that have managed to increase dividends every year while also increasing net return and maintaining a cap on the debt level relative to total capitalization. And in those cases, option profits do not suffer, even though overall market risk is lower.
This comes down to a logical conclusion: You do not need to take equity positions in volatile and high-risk stocks to achieve better than average returns on options. This is true especially for covered calls and uncovered puts. It is a mistake to make selections on any one fundamental test, such as dividend yield or dividend per share. That test makes sense only when studied in conjunction with long-term debt trends and net return. These tests should be applied over several years. The examples of Lockheed Martin and Philip Morris made this point. Both paid impressive dividend per share and increased the dividend every year without fail. For some investors and traders, this test is enough. But it does not tell the whole story.
No single test – fundamental or technical – is reliable enough to use exclusively. The strength of a fundamental indicator is made more powerful when two or more factors are considered. This idea – for example, evaluating several years of dividend yield, dividend per share, debt to total capitalization ratio, and net return, makes the analysis more insightful and leads to more informed decisions.
Options traders easily fall into the trap of focusing just on premium yield, while ignoring degrees of risk in the underlying. Even though many traders shun fundamentals and favor technical analysis, there is value to be gained from articulating the fundamental strength or weakness of the underlying as a starting point. This emphasis also leads to insights about the value of historical volatility (a true test of risk) versus the fuzzy estimates and unreliable conclusions of implied volatility.
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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