How Dividends Impact Options Pricing

by Gavin in Blog

August 17, 2020 • 2 comments

While there are many factors that impact option prices, one of the most frequently overlooked is dividends.

Since dividends impact options indirectly (by impacting the price of the underlying), and since dividends occur rarely, (typically quarterly or bi-annually), traders sometimes forget to keep them on their radar when making investment decisions.

While the impacts of dividends are rarely as great as the impacts of big events like an earnings report, prices are likely to fall more than average so it is worth keeping an eye on.

This is particularly important when trading anytime around the first trading day that doesn’t include the upcoming dividend (called the ex-dividend date) as this is where the largest price changes are concentrated.

This article will explore what a dividend payment is, what happens when it is paid, and how a dividend payment then affects the price of an option.

Contents

• What Is A Dividend Payment And How Is It Paid?
• How Do Dividends Affect The Price Of An Option?
• Conclusion

What Is A Dividend Payment And How Is It Paid?

What Is A Dividend Payment And How Is It Paid?

Over time, as a company begins to generate profits, the owners (shareholders) will increasingly be seeking a way to extract a share of those profits for themselves.

One of the ways this can be achieved is by having the company distribute a portion of those profits directly to shareholders via a dividend payment.

To ensure only valid shareholders receive a dividend, the company will announce a record date.

Simply put, the record date is the cut-off date by which an investor has to hold a share of the stock before they are eligible to receive a dividend.

Since stock transactions take two days to settle (known as T+2), investors need to make sure they own the stock before the record day arrives if they want to receive a dividend.

The most important date for options traders working with dividends is the ex-dividend date, which is the first trading day that doesn’t include the upcoming dividend payment.

On this day, the company that issued the dividends begins trading at a value which is decreased by the amount of dividends that were paid.

This happens because the company has paid out a certain amount of money to investors and so it no longer has that money on its balance sheet, making it worth less.

This means that the price of the stock usually falls, with the magnitude influenced by the value of total dividends paid to all eligible shareholders.

Of course, many factors influence stock market prices, so investors shouldn’t assume that the price will fall by an exact amount equal to the fall in balance sheet value from dividends paid.

As the price of the stock falls, this impacts related options, which will be covered in the next section.

How Do Dividends Affect The Price Of An Option?

In the lead up to the ex-dividend date, the price of put options increases while the price of call options decreases.

This is due to the fact that a drop in price is anticipated on the ex-dividend date and this is priced in by traders.

Firstly, put options provide the owner with the right to sell shares of stock at a specified strike price up until the expiration date.

As a reward for taking on this risk, the writer (seller) of the option receives a premium.

Since the price of the stock is known to fall on the ex-dividend date, it makes a put option more profitable and therefore more attractive and costly.

As for call options, they provide the owner with the right to buy shares of stock at a specified strike price up until the expiration date.

A fall in the value of the stock means that a call option will be worth less as the owner is betting on a price increase.

Given that the ex-dividend date is known well in advance, the change in option prices can start to be priced-in many days or weeks in advance.

As a result, traders may find that in some instances, when they purchase or sell options within a few days of the ex-dividend date, the price doesn’t change in response to dividends being paid.

Likewise, for options purchased well in advance, they could have a violent move, particularly if an unexpected special dividend is announced (for example as the result of a record year of profits).

Understanding these general principles are all well and good, but can traders work out the exact change in price?

Unfortunately, there’s no easy and highly reliable way to do it, but the most popular way is to use a tweaked version of the Black-Scholes formula (which is the formula used for pricing options).

The Black-Scholes formula is used to price European style options, which unlike American style options, cannot be exercised before the expiration date and the underlying stock does not pay a dividend.

However practically speaking, investors rarely exercise options before expiration date as it means missing out on the remaining time value of the option.

As a result of this, the formula can still serve as an appropriate proxy for pricing American style options provided you tweak the formula to consider dividends.

While there are many ways to do it, the most common method is to find out the discounted value of a future dividend and to subtract it from the price of a stock.

Conclusion

Dividends are distributions of excess profits from companies to their shareholders.

This process causes a drop in the value of the business, equal to the total value of the dividends paid.

A company’s stock price generally falls after a dividend is paid, however, the magnitude of the fall is influenced by dividends and other factors, making only a reasonable estimate possible.

The most important date for traders to keep in mind is the ex-dividend date, which is the first trading day after dividends have been paid.

The ex-dividend date is the day when the fall in stock price will take place as the company is now less valuable, trading without the cash that was used to pay dividends.

As a result of dividends pushing down the price of underlying shares, put options are likely to increase in price while call options are likely to decrease in price.

Since ex-dividend dates are known well in advance, these price moves can sometimes be priced in weeks ahead of the ex-dividend date.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.