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Found 5 results

  1. Michael C. Thomsett

    Options: Debt and Net Return

    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. Related articles: 3 Dividend Traps To Watch For Dividends And Options What Options Traders Need To Know About Dividends The Effect Of Dividends On Options Pricing
  2. Michael C. Thomsett

    The Effect of Dividends on Options Pricing

    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: 3 Dividend Traps To Watch For Dividends And Options What Options Traders Need To Know About Dividends
  3. Michael C. Thomsett

    3 Dividend traps to Watch For

    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. Related articles: Dividends And Options The Effect Of Dividends On Options Pricing What Options Traders Need To Know About Dividends
  4. Michael C. Thomsett

    What Options Traders Need to Know About Dividends

    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. Related articles: 3 Dividend Traps To Watch For The Effect Of Dividends On Options Pricing Dividends And Options
  5. cwelsh

    Dividends and Options

    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. Related articles: 3 Dividend Traps To Watch For The Effect Of Dividends On Options Pricing What Options Traders Need To Know About Dividends