Option Trading – Watch Those Dividends

Most people are aware that when a company pays a dividend, the price of its stock is expected to drop by roughly the amount of the dividend. This has special implications for option trading.

The reason that a stock drops after a dividend is pretty clear. To see why, imagine that it was not expected to happen.

Let’s assume that a $78 stock has a dividend coming up, which is expected to be about $1.00. The ex-dividend date is, let’s say, December 21. Whoever owns the stock at the close of business on the trading day before the ex-dividend date, December 20 in this case, will receive the dividend two weeks later. Whoever buys it on or after December 21 will buy it ex-dividend (without the dividend).

In our hypothetical scenario where the price doesn’t drop, knowing that a dividend is coming up a trader could buy the stock at one minute before the close of business on December 20. He would then be on the books as the owner and would receive the dividend a few weeks later, on the payment date. It is not necessary, by the way, to own the stock on the payment date to receive the dividend. So, the trader could sell the stock at the open of the market on the ex-dividend date of December 21 knowing that he had locked in the $1 dividend payment.

What’s wrong with this scenario is that if it existed many people would take advantage of it, and that would stop it from working. The demand for the stock in the few days before the ex-dividend day would go up as people bought to acquire the dividend. This would push up the price of the stock until it was above its “normal” price by about the amount of the dividend. Then the next morning when all the people who were following that strategy sold their shares, the excess supply would push the stock back down again, about to where it started. There would be no net gain to the dividend-strippers – they would simply have generated dividend income of $1 and an offsetting capital loss of $1.

What actually happens is that the closing stock price on the day before the ex-dividend date is adjusted downward by the amount of the dividend. When it opens the next morning, that adjusted close price is the peg against which the current day’s movement is measured. If it actually opens $1 lower after a $1 dividend, it is considered unchanged from the previous day.

Below is a real-life example. IYR, the iShares US Real Estate Exchange-traded Fund, had a dividend coming up with an ex-dividend date of December 21. Based on past history, the dividend was expected to be about $1.00.

From the close on December 20 to the open on December 21, the stock dropped by $1.02. So anyone who bought the stock on December 20 or earlier had a loss of $1.02 on the stock to start the day, which offset the $1.07 dividend that they would receive.

For options, this expected drop in the stock price has particular implications. If a specific change in the stock price can be reasonably expected, then it will be built into the prices of the options on that stock ahead of time. Then, when the dividend date arrives the option prices will realign to remove the adjustment for the anticipated dividend (which is now in the past).

When the price of a stock goes down, all of its call option prices will go down and all of its put option prices will go up. If a drop in the stock price is anticipated (because of a dividend), then that expected drop makes all the call prices lower than they would otherwise have been, ahead of time. It also makes all the put prices higher than they otherwise would have been.

Here are the implications for option traders:

1. Be aware of the ex-dividend dates and amounts of stocks whose options you are considering. A good reference for this is NASDAQ’s dividend page. You can enter any stock’s symbol to see its dividend history.

2. When calculating stops and targets based on the stock price, take the probable drop on the ex-dividend date into account.

3. Expect the readjustment in all option prices on the ex-dividend date. The gap between the amount of time value in calls and that of puts will narrow abruptly on the ex-dividend date.

4. Because of these complications, option strategies on high dividend-paying stocks are especially challenging. One way to avoid those complexities is simply to select for your advanced option strategies those stocks with no dividends or low dividend rates, say less than 1% annual yield. This doesn’t apply if you are using simple covered calls to increase income on long-term positions.

Option trading is a powerful way to profit from your market outlook. Knowing the role of dividends can give you a strong edge.

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