Top Three Lessons for Options and Dividends for 2016
Doc Severson, TheoTrade.com
Yes, I know what you’re thinking - DIVIDENDS?!! Aren’t they for the retiree who watched “Wall Street Week with Louis Rukeyser” and listened to his broker’s advice to “hold for the long run?” Well, in this world of ZIRP (zero interest rate percent) or even in some cases NIRP (negative) a paltry 3% dividend yield becomes like a rare earth magnet, attracting capital from around the globe. Dividends have turned into one of the only sources of “fixed” return in the financial universe, with the US Stock Market becoming a safe harbor in light of global uncertainty.
With this in mind, it should not surprise you that dividend-paying companies are being accumulated in 2016 like tech stocks in 1999. Companies that were considered “boring” such as WalMart (WMT) or Clorox (CLX) are in strong uptrends because of this effect. In 2016, Dividends are “front and center” now, so it’s time for the savvy Options trader to dig in and find out a little more about them. With that in mind, here are the top three lessons for options traders when it comes to dividends:
1) What are Dividends?
A Dividend is a payout to shareholders of a company’s stock, which is a redistribution of corporate earnings regardless of what happens to the actual stock price. This payout usually occurs on a quarterly basis, however it can occur more or less frequently than that depending on the dividend schedule of the individual stock in question.
Let’s see the nuts and bolts of this on a large ETF stock such as the SPY (the S&P500 ETF) by pulling up this information on our broker’s interface on the SPY:
Let’s see what the dividend-specific data points are on the SPY:
- Div - This stands for the “Dividend” and is the amount paid out per-share to shareholders that owned the stock on the “date of record,” which the date that the trader must own the stock in order to receive the dividend.
- Yield - The yield percentage is calculated by this formula:
Dividend Yield = (Annual Dividends Per Share)/ Price Per Share
So for the SPY, a dividend payment of $1.05 paid out 4 times for a total of $4.20, divided by the per-share price of $205.48. If you do the math, you’ll get the 2.04% yield figure.
- Div Freq - This is the frequency that the dividend is paid out, which in this case is Quarterly, or four times/year.
- Ex Div Date - This is the date that the dividend is removed from the stock, or “priced in.” As we’ll see in a minute, this is really the most important date that option traders care about.
OK, now that we’ve seen what the nuts & bolts are of dividends, let’s continue with the next two important points.
2) Assignment and Dividend Payment
Here’s one of the many little “land-mines” of options that we all seem to find sooner or later; you might be assigned short stock shares and have to PAY that dividend! Let’s break this down, by first discussing one “known” fact:
- Holders of “short stock” shares are the ones paying that dividend. In the data above on the SPY, holders of short stocks shares on the SPY would be paying that quarterly dividend payment of $1.05 per share per quarter that they held the short shares, on the Ex-Dividend date.
At this point you might be saying to yourself, “Whoa….I didn’t know that. Good thing that I never intend to own short stock shares!” And this is where you’d be wrong if you were a short call option holder trading something like a call credit spread or debit spread, or if you held a call calendar spread. There are any number of strategies that feature a short CALL option close to the “money.” Let’s bring up our second fact now:
- Only short call holders are at risk of paying the dividend. Short put holders do not have dividend risk.
So how would you, as a short call holder, be liable for the dividend payment? Only if you were “assigned” the short shares with 100 short shares for every short call option that you traded.
We know that by selling an option, we hold an obligation, and in the case of short calls, we hold the obligation to sell someone shares at a specific strike price. When and how can this change around the ex-dividend date? That brings us to point number three, which are “risks of assignment.”
3) Risk of Assignment
At this point we know that dividend payment risk will occur only when we have short call options that are either “in the money” or “near the money” on the ex-dividend date. Payment occurs if your short call options are assigned as short stock shares, in which case you are liable for the dividend payment.
So right out of the gate, it stands to reason that:
- If you don’t want to risk assignment and paying the dividend, don’t hold short options near or in the money near the ex-dividend date!
I make it a general practice to know and track all of the possible ex-dividend dates for any stocks on my watchlist, because I don’t like nasty surprises like that. And I will either choose to just NOT TRADE over that cycle if there is possible dividend risk, or simply make a note to close positions that are closer to the money prior to ex-dividend.
There is also a little-known fact on how options are priced into the “chain” prior to ex-dividend; the price of the dividend will be already factored into the price of the put options just before the ex-dividend date, primarily because the price of the underlying stock will drop by approximately the price of the dividend on ex-dividend day.
You can see in this chain how IBM, which is about to pay a $1.40 dividend, has the 146 puts priced significantly higher than the 146 calls:
So here’s the guidance behind this:
- In order to determine if your short calls are at risk of assignment, look at the corresponding puts at that strike price. If the corresponding puts are trading for LESS than the dividend amount, you are HIGHLY LIKELY to be assigned on ex-div!
In this example you can see how the 146 puts are priced significantly lower than the $1.40 dividend, so holders of those 146 short calls need to close their positions if they don’t want to be the proud owners of short shares of IBM on the ex-dividend date.
Summary
As you can see, dividends can definitely be an additional source of income but simply scanning for high dividend yields will often lead to poor results. For most options traders, ex-dividend dates amount to extra risk not unlike that which surrounds an Earnings release, however the risks around dividend payments can be mitigated with some simple tracking and research.
There are many other nuances of dividends as to how they affect options trading, all of which are discussed in depth in our chat room and archives for TotalTheo members.
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