Dividends usually bring smile on the faces of most investors except for some. Declaration of dividend by a company may upset a few people. Just ask an option trader holding a call option and you will know. Dividends have an adverse effect on call option prices. I assume you have some idea about options and must be aware of the basics of options trading. Let’s understand how a dividend affects the price of an option.
Dividends – effect on option prices
Dividends are one of the most important factors in the Extended Black-Scholes Option Pricing Model, which affect the premium of any option, whether call or put. And obviously dividend affects the price of call and put options in different ways.
Whenever a dividend is declared on a stock, the market discounts the dividend in the market price of the stock and hence the ex-dividend price of the stock is lower. This price adjustment in turn affects the price of the options.
Effect on Call Options
In case of a call option, the premium decreases with the declaration of dividend. On the ex-dividend date the market price adjusts for the cash dividend declared. This in turn results into decrease in the price of the call option attached with the stock.
Effect on Put Options
The opposite happens in the case of put options. With the fall in the market price of the underlying stock, the put option becomes more attractive and hence the premium of such a put option rises.
Let’s see some illustrations to make things clear.
Illustration (a): Option pricing without dividend.
The Current Market Price of Apple Inc. was $409.22 as on 1st of July, 2013.. If we calculate the premiums of options of Apple Inc for the September 21st, 2013 at-the-money contracts ( i.e. strike price $410), the prices come out to be $20.7038 for Calls and $21.2683 for the Puts with the conditions as per the above illustration. In this case it has been assumed that there is no cash dividend declared.
Now consider the situation where a future cash dividend of $3 has been declared on each share of Apple Inc.. This dividend will get discounted in the price of the shares of Apple Inc.. and the ex-dividend price will become approx $406. This fall in the price of the underlying shares of Apple Inc. in turn is reflected in the option prices as discussed above. The illustration below shows the new prices with dividends taken in purview.
Illustration (b): Option pricing with dividend.
As evident from the illustrations above, you can see that with the decrease of $3 in prices of shares of Apple Inc., the Call option becomes less attractive and the price drops to $19.2815 (a decrease of $1.4223).. On the other hand the put option is now better placed and its price rises to $22.7459 (an increase of $1.4776).
The effect of dividend is not of much importance in case of European Options as they can be exercised only on Expiry Date. By the time of expiry date these factors have already been adjusted in the prices. It can be observed clearly in case of American Options because of the fact that you can exercise the option before the expiration date as well. Also a naked option is more prone to the dividend effect. The effect gets neutralized in case of a covered call as the decrease in option prices is compensated by the dividend received on the stocks. Although this compensation may not be proportionally equal.
OP’s comment– In future posts on OptionPundit I shall explain about some dividend focused option trading strategies. If you would like to stay informed, pls join our mailing list for FREE educational articles. Should you have any questions, feel free to ask us anytime-> ask@OptionPundit.com
(This guest post was written by Mr. Patrik Fonce who is a trader and also an editor for quantshare.com)