Long call option traders avoid ex-dividend stock inequality by exercising the call and becoming a shareholder of record. Just watch timing and new stock risk.
By Ticker Tape Editors October 28, 2015 4 min read
Ex-dividend risk refers to the potential loss that traders face when they fail to exercise long option calls on dividend-paying stocks. Collectively, traders who misunderstand this risk—or don’t know how to avoid it—needlessly wave buh-bye to beaucoup bucks market-wide every time a stock goes ex-dividend.
But before understanding ex-dividend risk, you must first grasp how dividends affect stock prices. This isn’t a lofty discussion about whether companies that pay dividends are better than those that don’t. But simply, a question: What happens to a stock’s price once it trades without the dividend?
For the Record
Let’s start with company XYZ paying a $0.50 per-share dividend. Who gets it? Shareholders of record, of course, which means that you have to buy the stock and go through the three-day settlement period before the company considers you on that record. But there can also come a day when the stock starts trading “excluding the dividend.” This is called the ex-dividend day, or sometimes ex-div for short. This is an important date for option traders to know.
Let’s assume XYZ shares are trading at $50 on Monday, and Tuesday is ex-div day. On Tuesday morning, assuming the stock opens unchanged on the day it’ll actually be trading at $49.50 a share. This looks like a 50-cent price drop for no apparent reason and for the stock owner it’s no big deal. There’s a dividend payment coming and that’ll make up that short-term blip.
But what about the trader who owns call options, specifically deep in the money (ITM) options? As an example, assume the 40-strike call on Monday is deep enough ITM and close enough to expiration that it’s pretty much a 100 delta call. That means that it moves penny for penny with the stock price.
So on Tuesday when the stock goes ex-dividend and is worth 50 cents less, these calls are also going to be worth 50 cents less. This also looks like a price decline. And guess what? It is. There’s no dividend payment coming to make up that dip.
This dip can easily be masked by market movement. For instance, what if the stock goes to $52? Then it’ll look like both the stock and the 40-call option prices have both gone up by $2. But the stock owner gets the dividend while the option owner does not. Some traders might just be happy to have a $2 price increase, but in the financial world this is still a needless option loss regardless of how you sugarcoat it. No matter where the stock moves on Tuesday, call option owners won't get the dividend like straight-up stock owners.
Thinking Exercise?
That dividend may eventually entice some option holders. By exercising the call and becoming a shareholder of record who’s entitled to the dividend. In order to have this status, though, you need to exercise your call option the day before ex-dividend day and actually purchase the shares of stock at the strike price of the option. If you wait until the ex-div day, you’re too late and will end up buying the stock excluding the dividend.
Keep in mind that call holders paid a premium for the option, then paid the strike price to own the stock, plus transaction costs and exercise fees. This obligation can require a lot of capital to get a dividend that may not be significant compared to the cash outlay.
One issue you might see with buying the stock is that now you’re on the hook for all of the risk that comes with buying stock. What if the stock craters?
Now, one strategy is to sell the call before ex-div. Or, you might employ a new strategy that potentially limits some of that risk. One potential fix is to buy a put option at the same strike as the call that you’re exercising. That limits the risk to the same amount you had by owning the deep ITM call, excluding transaction costs.
There’s still risk, of course. But by owning the stock, you now avoid the loss taken by so many option traders who are caught flat-footed on ex-div.
String on Your Finger?
The calendar tool on the thinkorswim® platform features corporate announcements including earnings, splits, dividends, and more, shown in figure 1.
Log in to your account, then go to MarketWatch > Calendar and select how you’d like to populate your calendar view. Clicking on the dividend icon opens more details, including the ex-div date. For illustrative purposes only.
FIGURE 1: NEW-LOOK THINKORSWIM® PLATFORM
Set only the alerts you want to see using the calendar tool on the thinkorswim® platform. For illustrative purposes only.
By Ticker Tape Editors
TDAmeritrade
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FAQs
Key Takeaways. Options listed on stocks are affected by the payment of dividends, since holders of the underlying shares receive dividends but call and put holders do not receive these inflows.
How to avoid dividend risk? ›
One preventative measure you can take to reduce the possibility of facing dividend risk through assignment is to roll short ITM calls for a credit to a further date. This compounds extrinsic/time value on the call and ultimately buys time for the relevant put value to become greater than the dividend value.
What impact does dividend have on call price? ›
A Call refers to when a purchaser enters into contract to buy stock on a certain date for a certain consideration. The decline of the stock price on the ex-dividend date results in a decline in the value of call options. The declaration of dividend observes a decrease in the premium of the call option.
Do I get dividends if I sell covered calls? ›
After you sell a covered call on XYZ, you collect your premium, and you still receive dividends (if any) and any potential capital gains on the underlying stock (unless it's called away).
Should I sell a call option before the ex-dividend date? ›
Options pricing with dividends
Traditionally, long call options involving a cash dividend would commonly (but not exclusively) be exercised on the day before the stock's ex-dividend date. That's because if an investor buys the stock on or after the ex-dividend date, the investor does not receive the dividend.
Will I get dividends if I sell on an ex-date? ›
The ex-dividend date is the first day of trading in which new shareholders don't have rights to the next dividend disbursem*nt. If shareholders continue to hold their stock, they may qualify for the next dividend. If shares are sold on or after the ex-dividend date, they still receive the dividend.
Is it better to buy before or after the ex-dividend date? ›
The Bottom Line. In order to receive a dividend, you must purchase a security before the ex-dividend date. On May 28, 2024, the ex-dividend date became the same as the date of record with the move to t+1 settlement. A security tends to drop by the the dividend amount on the ex-dividend date.
How do dividends work with calls? ›
Dividends offer an effective way to earn income from your equity investments. However, call option holders are not entitled to regular quarterly dividends, regardless of when they purchase their options. And, unlike stock or ETF prices, options contract prices are not adjusted downward on ex-dividend dates.
What happens to options on ex-dividend date? ›
Since option traders will anticipate a decline in the price of a stock prior to the ex-dividend date, the probability of that decline after the ex-dividend date will be incorporated into the price of a put, making it more expensive, as well as into the price of a call, reducing its value.
Do stock prices drop after dividend paid? ›
After a stock goes ex-dividend, the share price typically drops by the amount of the dividend paid to reflect the fact that new shareholders are not entitled to that payment. Dividends paid out as stock instead of cash can dilute earnings, which can also have a negative impact on share prices in the short term.
Answer and Explanation:
An unexpected cash dividend decreases the call option price. The reduction in the costs of options is analyzed after the announcement of the cash dividend. The option holder does not make prior predictions or estimations.
What happens to the value of a call option if the stock price increases? ›
An example of buying a call option
The graph below shows the buyer's profit or payoff on the call with the stock at various prices. Because one contract represents 100 shares, for every $1 increase in the stock price above the strike price, the total value of the option increases by $100.
What is a poor man's covered call? ›
The Poor Man's Covered Call is an option strategy in which a deep in-the-money call option with a long maturity is first purchased. Subsequently, a Call option sold with a shorter maturity (usually above the current share price).
When should you not sell covered calls? ›
You usually wouldn't want to sell covered calls when the market is very undervalued, for example. Covered calls are a useful tool, and in the hands of a smart investor in the right circ*mstances, can be tremendously profitable.
What is the best stock to sell covered calls? ›
Best stocks for covered calls
- Oracle (NYSE: ORCL) ...
- Pfizer Inc. ...
- Advanced Micro Devices (NASDAQ: AMD) ...
- Ford Motor Company (NYSE: F) ...
- ConocoPhillips (NYSE: COP) ...
- Verizon Communication (NYSE: VZ) ...
- Devon Energy (NYSE: DVN) ...
- Nvidia (NASDAQ: NVDA)
Dividends offer an effective way to earn income from your equity investments. However, call option holders are not entitled to regular quarterly dividends, regardless of when they purchase their options. And, unlike stock or ETF prices, options contract prices are not adjusted downward on ex-dividend dates.
Do employee stock options pay dividends? ›
I will limit this discussion to restricted stock units (RSUs) and restricted stock awards (RSAs); as an employee who owns stock options, you will not receive dividends until you exercise the option and become a shareholder.
Do long calls pay dividends? ›
A call option owner is not entitled to receive dividend. Fortunately, the computer models that calculate option prices consider this. This means that call options on dividend-paying stocks will be a little more expensive and put options will be a little more expensive.
What is the dividend strategy with options? ›
The dividend play strategy will be profitable on the series for which (1) the option's expected time value is lower than the amount of the dividend, and (2) the open interest going into the ex-dividend day is positive. The first condition implies that the option should be exercised early.
