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When it comes to stocks, options and dividends, there is no free lunch

Have you ever bought a long put on a dividend paying stock just prior to the stock going-ex dividend. You thought the long put would gain value when the stock value decreased by the amount of the dividend, but it didn’t work out, did it? So, what went wrong?

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Many companies pay dividends. Companies like Abbot Laboratories (ABT), Avon Products Inc. (AVP), Chevron Corp. (CVX), ConocoPhillips (COP), Intel Corporation (INTC), Lockheed Martin Corporation (LMT), McDonald’s Corp. (MCD), Pitney Bowes Inc. (PBI), SUPERVALU Inc. (SVU)and many, many others. What these all have in common is the price of the stock goes down by the amount of the dividend when the stock goes “ex-dividend.” Logically, you might think because the stock is lower in value that a long put should in fact gain value. Sadly, there is no free lunch in trading and the market and the market makers are also well aware of the dividend of the underlying stock.

So how does the market account for these dividends in an options price? In the case of the long put option it’s pretty clear. The market simply adds the amount of the dividend to the extrinsic value of all the put options. Once the stock goes ex-dividend and the stock falls by the amount of the dividend, then the market takes the extrinsic value of that dividend back out of the price of the put.

Since a reduction in the stock price would cause a long put to go up in value and a long call to go down in value, and if the put’s price is simply inflated by the dividend amount as extrinsic value, then how can the market adjust the value of a call? Certainly we cannot introduce a negative extrinsic value to the call’s price, and we certainly can’t reduce the intrinsic value of an in the money call option. Intrinsic value is what it is: the difference between the current equity value and the strike price of the option. So, about the best the market can do is to reduce the extrinsic value to almost zero.

So, on the surface it would seem it might make good sense to sell in the money calls prior to the stock going ex-dividend. You may think if you sell an in the money call option, that the call option will be made up primarily of intrinsic value. So, when the underlying equity goes ex-dividend and the stock price goes lower, you’ll then buy back the short call at a significantly lower price. The difference between what you sold to open the option and what you bought to close it would be your theoretical profit. Of course the market is wise to this type of behavior as well.

While very few paper trading platforms have the capability of handling early options assignment, the real world is quite another story. In the real world, the market maker has reduced the amount of extrinsic value associated with a call option. So, the dividend in general is greater than the extrinsic value of an in the money call option. It makes sense, then, that the holder of the long call option would exercise their option just prior to the stock going ex-dividend to acquire the stock at the strike price of the option as well as to capture the dividend. The result is that your short call is assigned before you have an opportunity to take advantage of the stock going ex-dividend.

What about out of the money calls? Take a look at an options chain in a near term expiration series with an equity about to pay a dividend. You’ll notice there is almost no premium at the out of the money strikes.

As always, the most important question we can ask as we become better traders is, “what if?” The answer to that question will lead us on a path with no real end, but continues to unfold in front of us. As we progress further and further down this path, our knowledge becomes greater and greater. Slowly but surely through this quest for greater understanding and knowledge, we begin to develop an edge in our trading that others don’t enjoy.

Jeff McAllister
OptionsANIMAL Instructor

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