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The Impact of Dividends on Covered Calls

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So you think you’ve found an easy way to capture the dividend on a stock for free using covered calls. Simply buy the stock before the ex-dividend date and sell a deep in-the-money covered call. On ex-dividend date, the stock drops by the dividend amount, but so does the covered call so the two net out and you collect the dividend basically for free.

All sounds wonderful in theory doesn’t it?

Think about this for a minute though. Who is on the other side of your trade? Possibly a trader from Goldman Sachs with 10 times more experience trading options than you?  Do you really think that a professional trader is going to leave money on the table like that?

Remember there’s no free lunch in this game. If it seems too good to be true, it probably is.

Yes, this strategy may have been valid in the past before options became mainstream, but most traders will tell you, this type of arbitrage opportunity disappeared 10 to 20 years ago.  Sorry, I hate to burst your bubble.

Options pricing is all computer driven now and any mispricing opportunities are exploited within seconds.

It’s important to remember that dividends are already incorporated into options prices. So that deep in-the-money call mentioned earlier was possibly trading for less than the intrinsic value.

This article has some good examples on the impact of dividends on option prices.

Sticking to bread and butter covered calls is a much safer strategy than trying to trade for the dividend.

Remember that you will also face the risk of early assignment if you are trading deep in-the-money calls. If the dividend amount is more than the time value component of the call option, the call will likely be assigned.

Another factor to consider is the commission and bid ask spread. Deep in-the-money calls are thinly traded so are likely to have fairly wide bid-ask spreads, further decreasing your chances of making a profit on this strategy.

Dividends being incorporated into the option price occurs with all options, not just deep in-the-money calls. Let’s look an example.

On April 1, 2016 VZ was trading around $54.

The April 15, 2016 $54 calls were trading at around $0.34 and the puts were trading at $0.84.  Why such a big difference between the calls and puts?

VZ is due to go ex-dividend on April 6th for a $0.55 dividend. On that date, all else being equal, the stock will drop by $0.55 hence why the puts are about 50 cents more expensive than the calls.

The subject of dividends and how they affect options prices can take a while to understand for new traders, but hopefully now you have a better understanding. Just remember that dividends are already incorporated into the price of both call and puts and that there is no free lunch in the options game.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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