Dividends and Options

 2/28/2014

As I have said before, I like dividends. I think companies should reward their owners (which are the shareholders) for taking the risk of owning the shares by paying out a portion of their profits in the form of a dividend. As profits increase, so should dividends. Management sometimes forgets that it's the owner's money, not theirs.

This is opposed to stock buy backs, which I hate. Stock buy backs do the following 1) They reduce liquidity by taking stock out of the market. 2) They artificially prop up the stock price by distorting true supply vs demand 3) They basically serve as a way to reward the (already overpaid) management by supporting their stock options.

Now, on to how dividends impact option pricing. Dividends make puts more expensive and calls cheaper. The puts get more expensive because the downside insurance a put represents is offset by the dividend. The higher the dividend the more I am willing to pay for a put. Calls become cheaper for two reasons: One, a dividend makes a covered write (long stock, short call) more attractive. Two, the stock needs to make up the dividend because the strike price is not adjusted. Say XYZ is trading at 100 and pays a $1 dividend a week before expiration. And we have the 105 call. If XYZ opens at 99 ex-dividend the stock actually opens unchanged because the $1 "loss" in the stock was paid to the shareholders. But! The 105 call is instantly another dollar out of the money.

And let's not forget, dividends create extra, hidden, expirations. Deep ITM calls for all intents and purposes expire the day before a dividend is paid out (dividends are paid to shareholders, not option owners) and deep ITM puts expire for all intents and purposes the day after the dividend is paid out (there is less reason to hold on to a heavy put plus the stock).

By: Randall Liss, The Report Liss