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Effects of Dividends on Stock Options

What is the effect of dividends on the price of stock options?

Effects of Dividends on Stock Options - Introduction

Many options traders are ignorant about the effects of dividends on stock options. In fact, the classic Black-Scholes Model for options pricing does not even take dividends into consideration in the calculation of theoretical options premium. Do dividends payments really have negligible effect on the price of stock options? This tutorial shall explore the effects of dividends on stock options and what causes these effects in order to help you make better options trading decisions.

Effects of Dividends on Stocks

Before talking about the effects of dividends on stock options, we need to first understand the effects of dividends on the stocks itself. Why is this so? This is because stock options are derivative instruments and derive their value from changes in the underlying stock itself. Understanding what dividends payments do to stocks makes it easy and intuitive to understand its effects on stock options.

When a company makes a profit and decides to reward shareholders for investing in the company, the board of directors will decide on an amount payoff per share and give that money to shareholders of the company. That payment is known as a dividend. Because dividends reduce the cash holding and hence the total book value of a company, it should also reduce price per share of its stocks if there are no multiples involved. However, because there are multiples involved, meaning that shares of good companies are traded in a stock exchange at an inflated price, expected dividends do not usually move the price of the stock. However, if a non-dividend paying stock should suddenly declare dividends or that a high dividend rate is being declared, a noticable drop in the price of the shares corresponding to the amount of dividends declared would occur on the day the ex-dividend day is declared.

Effects of Dividends on Stock Options

As mentioned above, dividends payment could reduce the price of a stock due to reduction of the company's assets. It becomes intuitive to know that if a stock is expected to go down, its call options will drop in extrinsic value while its put options will gain in extrinsic value before it happens. Indeed, dividends deflate the extrinsic value of call options and inflate the extrinsic value of put options weeks or even months before an expected dividend payment.

Effects of Dividends on Call Options

Extrinsic value of Call Options are deflated due to dividends not only because of an expected reduction in the price of the stock but also due to the fact that call options buyers do not get paid the dividends that the stock buyers do. This makes call options of dividend paying stocks less attractive to own than the stocks itself, thereby depressing its extrinsic value. How much the value of call options drop due to dividends is really a function of its moneyness. In the money call options with high delta would be expected to drop the most on ex-date while out of the money call options with lower delta would be least affected.

This is also why many options traders exercise their deep in the money call options with close to zero extrinsic value just before the dividend payout date if they are trading American Style Options. Exercising the call options for the dividends will help to preserve the value of the position as the dividends recieved offsets the drop in price of the stock.

On the other hand, if you are holding in the money SHORT call options and they get exercised on dividend day, you will be assigned short stocks on which you would be liable to pay the dividends on! Yes, many options traders get trapped in such a situation especially when playing credit spreads that look like there are no risk as the credit receivable exceeeds the strike differences. However, that is only so due to the dividends payable on those positions. So many of them, thinking there is no risk, writes hundreds of these credit spreads and end up having to pay tens of thousands in dividends less the much smaller credit that they received.

Effects of Dividends on Put Options

The stock market never gives away money for free. If a stock is expected to drop by a certain amount, that drop would already have been priced into the extrinsic value of its put options way beforehand. There is no free lunch in options trading. This is what happens to put options of dividend paying stocks. This effect is again a function of options moneyness but this time, in the money put options raise in extrinsic value more than out of the money put options. This is because in the money put options with delta of close to -1 would gain almost dollar or dollar on the drop of a stock. As such, in the money put options would rise in extrinsic value almost as much as the dividend rate itself while out of the money put options may not experience any changes since the dividend effect may not be strong enough to bring the stock down to take those out of the money put options in the money.

Another justification for the higher extrinsic value of put options on dividend stocks is due to the fact that if you are short a dividend paying stock, you would be expected to pay back the dividends declared while no such payback is needed if you own its put options instead. This makes owning put options on dividend paying stocks more desirable than shorting the stocks itself.

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