People who trade options do so for several reasons: to target downside protection, to potentially enhance income from stocks they own, or to seek temporary directional exposure, to name a few. But one common element shared by all option traders is risk exposure.
Consider options dividend risk. If investors trade options on stocks that pay cash dividends, they need to understand how dividends affect options prices, options exercise and assignment, and other factors in the life cycle of an option.
To make a long story short: Failure to understand dividend risk could derail a trader's strategy and cost them money.
How do cash dividends work?
Dividends, stock splits, mergers, acquisitions, and spin-offs are examples of corporate actions—things done by a company that may require adjustments to the number of outstanding shares or the share price in order to keep the inherent value of each share consistent before and after the change.
Depending on the specifics of the corporate action, certain options contract terms and obligations, such as the strike price, multiplier, and the terms of the deliverable, could be altered.
With dividends, the stock price typically undergoes a single adjustment by the amount of the dividend. The stock price drops by the amount of the dividend on the ex-dividend date.1 Remember, the ex-dividend date is the day before the record date. If investors want to receive a stock's dividend, they have to buy shares of stock before the ex-dividend date. The record date is the date the company determines who are shareholders who receive dividends. (The ex-dividend date is before the record date to allow transactions of the trade to settle before the record date.)
For example, suppose a stock trading for $50 per share declares a $0.50 dividend. On the ex-dividend date, the price adjusts to $49.50 ($50 minus the $0.50 dividend) for each share as of the record date. And that's it—no changes to the listed options strike prices or contract terms.
From a shareholder standpoint, it would appear to be an even swap—$50 in stock versus $49.50 in stock plus $0.50 in cash—but call and put options prices must account for the decline in the stock value and the markets adjust accordingly.
It's important to note this adjustment to options prices isn't a sudden, unexpected change right after the ex-dividend date. Option traders anticipate dividends in the weeks and months leading up to the ex-dividend date, so options prices adjust ahead of time.
Put options generally become more expensive because the price drops by the amount of the dividend (all else being equal). Call options become cheaper because of the anticipated drop in the price of the stock leading up to the ex-dividend date.
In general, options prices ahead of a dividend payment generally reflect expected values after the dividend. But that assumes everyone who holds an in-the-money (ITM) option understands the dynamics of early exercise and assignment, and will exercise at the optimal time.
Options pricing with dividends
Let's take a step back.
Theoretical options values are derived from options pricing model formulas, such as Black-Scholes or Bjerksund-Stensland. These formulas use variables such as the underlying stock price, exercise price, time to expiration, interest rate, dividend yield, and volatility to calculate the fair value of an options contract.
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. So, an investor must own the stock before the ex-dividend date. Whomever owns the stock as of the ex-dividend date receives the cash dividend, so owners of call options might choose to exercise certain ITM options early to capture the cash dividend.
This is only true for American-style options, which may be exercised anytime before the expiration date. In contrast, European-style options can only be exercised on the expiration date.
Exercising a long call option before ex-dividend
Suppose XYZ is trading at $50, a trader is long the 40-strike call option that expires in one week, and XYZ is expected to pay a $0.50 dividend tomorrow.
The call option is deep ITM and should have an intrinsic value of $10 (stock price minus strike price) and a delta of or near 100. (Remember the multiplier—one standard options contract is deliverable into 100 shares of the underlying stock). So, the options contract has a similar price risk characteristic as 100 shares of stock.
Once the stock goes ex-dividend, the $50 becomes $49.50, and the owner of record gets the $0.50 dividend. With the stock at $49.50, the intrinsic value of the call option is reduced by that same $0.50. Of course, owning a call option doesn't entitle the holder to the dividend.
In other words, the $0.50 loss from the lower stock price is offset by the $0.50 dividend, so the option trader might consider exercising the option (and becoming the owner of the stock) rather than holding it—not because of any additional profit per se, but because they can avoid a $0.50 reduction on the call if they were to hold it through the ex-dividend period. Remember, this doesn't account for any contract fess or transaction costs, which could increase the loss amount.
With a deep ITM option, it's easy to see why early exercise might make sense. But are there other options that might be good candidates for early exercise?
Follow the time value
The answer lies in an options contract's extrinsic value, also known as its "time value" or "time premium." Remember, options prices are comprised of two components: intrinsic value, the amount by which an option is ITM; and extrinsic value, or the value over and above its intrinsic value based on the amount of time until expiration and the stock's implied volatility2 and other inputs to the theoretical pricing model.
When traders exercise a standard call, they receive 100 shares of the underlying stock for each contract at the strike price. They forgo any remaining extrinsic value in that call.
Let's look at another example: Suppose the 45-strike call is trading for $5.10. With the stock at $50, that would mean $5 in intrinsic value and $0.10 of time value. In this case, exercising the call would cost $0.10 in forgone time premium but entitle a trader to the $0.50 dividend, so it may still be worth exercising early if contract fees and transaction costs are low.
Any option that has an extrinsic value of less than the amount of the dividend might, more likely, be a candidate for early exercise.
Suppose a trader is long the 48-strike call and it's trading for $2.60 (with the stock still trading at $50). This would represent $2 in intrinsic value and $0.60 of time value. In this case, if they were to exercise the call, they'd stand to lose more in time value than they'd gain from the dividend if it were exercised.
Beware of put-call parity
It's important for traders to pay attention to long ITM call positions so they can consider strategically exercising calls before the ex-dividend date. But if they're short ITM calls on a stock that's about to go ex-dividend, they might want to pay closer attention.
Here's why: According to put-call parity3, a put and a call of the same strike and expiration date will have roughly the same amount of extrinsic value. A simple way for traders to see if they might be assigned on that short call is to look at the corresponding strike and price of the put.
Again, any option that has an extrinsic value of less than the dividend's amount might be a candidate for early exercise. If a trader is short an ITM call and the strike's corresponding put is trading for less than the upcoming dividend, they're more likely to be assigned.
In this situation, a trader might consider avoiding an early assignment ahead of a dividend by either buying back the call option or rolling it to another option, such as a higher call strike or a deferred expiration date.
1 The day on and after which the buyer of a stock does not receive a particular dividend. This date is sometimes referred to simply as the "ex-date" and can apply to other situations beyond cash dividends, such as stock splits and stock dividends. On the ex-dividend date, the opening price for the stock will have been reduced by the amount of the dividend but may open at any price because of market forces.
2 The market's perception of the future volatility of the underlying security directly reflected in the options premium. Implied volatility is an annualized number expressed as a percentage (such as 25%), is forward-looking, and can change.
3 The price relationship of puts and calls of the same class, such that a combination of these puts and calls will create the synthetic equivalent of a stock position. For example, a combination of a short 50-strike put, with a long 50-strike call of the same expiration and same underlying, generally has the same risk-return profile as the underlying stock position.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Certain requirements must be met to trade options through Schwab. Please read the Options Disclosure Document titled "Characteristics and Risks of Standardized Options" before considering any option transaction.
Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.
With long options, investors may lose 100% of funds invested.
American style short options can be assigned at any time up to expiration regardless of the in-the-money amount.
Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.
Rolling strategies can entail additional transaction costs, including multiple contract fees, which may impact any potential return.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.1023-3M1N