Understanding Dividends and Options Trading

As an MTM one-on-one coach, I field a variety of questions from my students on a day-to-day basis. One consistent line of questioning derives from dividends and options trading. If you trade options on stocks that pay cash dividends, you need to understand the mechanics of how dividends affect options prices, options exercise and assignment, and other factors in the life cycle of an option.

Some questions my students have asked:

  • What happens to my calls if a company suspends the dividend like Ford did last year?
  • When should I exercise calls if there is an upcoming dividend?
  • A stock I own is beyond the payable date, why don’t I see the dividend hitting my account?

Let’s kick things off with a review of the most important and relevant terms. Each of the topics I define below comes into play with regards to decisions you must make if you are long options, or how you may be subjected to the decisions of a contra-side trader if you hold a short options position. Understanding these key terms are the “keys to the kingdom” as far as how dividends affect options. Mastering these terms will help you avoid getting burned in the future.

Theoretical Pricing Model of Calls and Puts

Call Theoretical Value = Parity (Intrinsic Value) + Interest (xrt/365) - Dividends + Volatility Value

Put Theoretical Value  = Parity (Intrinsic Value) - Interest (xrt/365) + Dividends + Volatility Value

From these options pricing formulas, one can easily deduce how a declared dividend increase or decrease can substantially impact the value of your positions. Important to also note are the different styles of options available to traders.

American vs. European Style Options

American-style options are the options most traders are accustomed to. All equity options in the U.S. are American-style and can be exercised (and you can be assigned) prior to and on expiration day. The added flexibility allows the trader the ability to exercise early for a dividend.

European-style options are utilized in the SPX, the NASDAQ Index or the Russell 2000 Index. The characteristic difference between Euro- and American-style options is that Euro-style options cannot be exercised prior to expiration day.

Dividend Declaration Date

When a company’s board of directors publicly announces the amount of the next, upcoming dividend and other important dates, a typical corporate dividend declaration reads like this:

“Company today announced its Board of Directors declared the cash dividend for its fiscal second quarter of 2021 of $0.07 per share. The dividend will be paid on June 29, 2021 to all stockholders of record as of June 15, 2021.”

You should scan the news daily so you are aware of any corporate announcements. When I see a dividend declaration, I religiously enter the dates into my calendar. I also set a reminder to warn me of the subsequent time-sensitive decision I will be required to make (do I exercise or not).

Record Date

This is the deadline by which a trader needs to own the shares to be eligible to receive the dividend. This date is mandated and enforced rigorously by the company to allow them time to ascertain the exact amount of dividends to pay out.

Ex-Dividend Date

For options traders, this is the most crucial date to know. Because stock trades now take two trading days to clear/settle (T+2), the ex-dividend date usually falls two days prior to the record date. Traders who want to receive the dividend need to purchase the stock prior to the ex-dividend date to receive the dividend. Holders of long calls must exercise to receive the dividend. This allows the exercised call to convert to shares and settle in time to be included in the dividend payable. Don’t forget!

On the ex-dividend date, assuming there is no change in the underlying price, the value of the stock will be reduced by the amount of the dividend on the opening print. This is because the company distributes those dividend funds out of their coffers and the company is now worth less.

If you do not exercise long calls prior to the ex-date, those calls will automatically be worth less the dividend amount. This becomes evident immediately with the display of the options prices from the opening rotation. Rule of thumb for holders of long calls is to exercise only if the dividend received exceeds the theoretical value of the corresponding put.

What about resting GTC orders? Some brokers make an accommodation for their customers and will move limit orders to account for dividend payments. Some do this automatically and some will do it if you ask. Some won’t do it at all and will require you to manually adjust. Some brokers have a setting that is buried somewhere in their software you can adjust to take advantage of this service they offer. Be sure to ask about this.

Payable Date

The funds from a dividend payable to you could take four to six weeks to get to you after the ex-dividend date passes. Sometimes when the payment date arrives the company chooses to disburse the funds to the broker instead of the shareholder directly. After holding onto your funds for a day (or two or three), the broker will transfer the dividend payment to your account. Those little dividends and the day (or two or three) they hold them for can really add up over time.

I hope this explanation of the mechanics of dividends and their impact on options trading has been helpful. As with options trading in general, the more you know, the higher your win-rate will be. Knowledge is your friend. Take care of yourself and happy hunting!

Joe Leska, Market Taker Mentoring




Trader Education