American-style options can be exercised at any time before expiration
Addressing dividend risk involves comparing the amount of a dividend against an options position’s extrinsic (time) value
People who trade options do so for a number of reasons: to target downside protection, to potentially enhance income from stocks they own, or to seek capital-efficient directional exposure, to name a few. But one common element shared by all option traders is exposure to risk.
Consider dividend risk. If you trade options on stocks that pay cash dividends, you need to understand how dividends affect options prices, options exercise and assignment, and other factors in the life cycle of an option.
To make a long story short: Failure to understand dividend risk could derail your strategy and cost you money.
How Do Cash Dividends Work?
Dividends, stock splits, mergers, acquisitions, and spin-offs are examples of corporate actions—things done by a company that require adjustments to the number of outstanding shares or the share price in order to keep the inherent value of each share consistent before and after the corporate action. Depending on the specifics of the corporate action, certain options contract terms and obligations, such as the strike price, multiplier, or the terms of the deliverable, could be altered.
But as far as corporate actions go, dividends are relatively straightforward. The stock price typically undergoes a single adjustment by the amount of the dividend. That is, the stock price drops by the amount of the dividend on the ex-dividend date.
So, for example, suppose a stock trading for $50 per share declares a $0.50 dividend. After the ex-dividend date (all else equal), it becomes a $49.50 stock (plus the $0.50 dividend) to the owner of each share as of the “record date.” That’s the cutoff day, set by the company, for receipt of a dividend. And that’s it—no changes are made to the listed options strike prices or contract terms.
From a shareholder standpoint, it’s essentially an even swap—$50 in stock versus $49.50 in stock plus $0.50 in cash—but call and put options prices must account for the decline in the stock value and adjust accordingly.
It’s important to note, though, that this adjustment to options prices isn’t a sudden, unexpected change right after the ex-dividend date. Option traders anticipate dividends in the weeks and months leading up to the ex-dividend date, so options prices adjust ahead of time.
Put options generally become more expensive because the price drops by the amount of the dividend (all else being equal). Call options become cheaper because of the anticipated drop in the price of the stock leading up to the ex-dividend date.
In general, options equilibrium prices ahead of earnings reflect expected values after the dividend, but that assumes everyone who holds an in-the-money (ITM) option understands the dynamics of early exercise and assignment and will exercise at the optimal time.
Options Pricing with Dividends
Let’s take a step back.
Theoretical options values are derived from options pricing model formulas such as Black-Scholes or Bjerksund-Stensland. These formulas use variables such as the underlying stock price, exercise price, time to expiration, interest rate, dividend yield, and volatility to calculate the fair value of an options contract.
Traditionally, long call options involving a cash dividend would be exercised only on the day before the stock’s ex-dividend date. That’s because if an investor buys the stock on or after the record date, the investor does not receive the dividend. So, an investor must own the stock before the ex-dividend date. Whoever owns the stock as of the ex-dividend date receives the cash dividend, so owners of call options might choose to exercise certain ITM options early to capture the cash dividend.
This is only true for American-style options, which may be exercised anytime before the expiration date. In contrast, European-style options can only be exercised on the expiration date.
When Is the Best Time to Exercise My Long Call Options Before Ex-Dividend?
Suppose XYZ is trading at $50, you’re long the 40-strike call option that expires in one week, and XYZ is expected to pay a $0.50 dividend tomorrow.
The call option is deep in the money and should have an intrinsic value of $10 (stock price minus strike price) and a delta of 100. (Remember the multiplier—one standard options contract is deliverable into 100 shares of the underlying stock). So the options contract has essentially the same price risk characteristics as 100 shares of stock.
Once the stock goes ex-dividend, the $50 becomes $49.50, and the owner of record gets the $0.50 dividend. With the stock at $49.50, the intrinsic value of the call option is reduced by that same $0.50. But of course, owning a call option doesn’t entitle the holder to the dividend.
In other words, the $0.50 loss from the lower stock price is offset by the $0.50 dividend, so you might consider exercising the option (and becoming the owner of the stock) rather than holding it—not because of any additional profit per se, but because you avoid a $0.50 loss on the call if you were to hold it through the ex-dividend period.
So with a deep ITM option, it’s easy to see why early exercise makes sense. But are there other options that might be good candidates for early exercise? What about the 45-strike call in the scenario described earlier—should you exercise that one as well?
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Follow the Time Value
The answer lies in an options contract’s extrinsic value, also known as its “time value” or “time premium.” Remember, options prices are made up of two components: intrinsic value—the amount by which an option is in the money—and extrinsic value, or the value over and above its intrinsic value, based on the amount of time until expiration and the implied volatility of the stock.
When you exercise a call, you’re essentially swapping the call for the underlying stock, at the strike price, and forgoing any remaining extrinsic value in that call.
Let’s suppose the 45-strike call is trading for $5.10. With the stock at $50, that would mean $5 in intrinsic value and $0.10 of time value. In this case, exercising the call would cost $0.10 in forgone time premium but entitle you to the $0.50 dividend, so it’s still worth exercising early.
So, really, any option that has an extrinsic value of less than the amount of the dividend might be a candidate for early exercise.
Suppose you’re long the 48-strike call and it’s trading for $2.60 (with the stock still trading at $50). This would represent $2 in intrinsic value and $0.60 of time value. In this case, if you were to exercise the call, you’d stand to lose more in time value than you’d gain from the dividend if you were to exercise.
What If I’m Short an ITM Call in a Stock That’s About to Pay a Dividend?
It’s important to pay attention to your long ITM call positions so you can strategically exercise calls before the ex-dividend date, but if you’re short ITM calls on a stock that’s about to go ex-dividend, you might want to pay closer attention.
According to put-call parity, a put and a call of the same strike and expiration date will have the same amount of extrinsic value. So a simple way to see if you might be assigned on that short call is to look at the corresponding strike and price of the put.
Again, any option that has an extrinsic value of less than the amount of the dividend might be a candidate for early exercise. So if you’re short an ITM call and the strike’s corresponding put is trading for less than the upcoming dividend, you’ll most likely be assigned.
Perhaps the best course of action to sidestep an early assignment ahead of a dividend is to either buy back the call option or roll it to another option, such as a higher call strike or a deferred expiration date.