Dividends are cash payments made by corporations to their shareholders. A regular dividend can be quarterly, or biannual or annual or perhaps even less frequent. Often the amount and date is announced along with quarterly earnings. Dividends are paid to shareholders of record on a certain date. The ex-dividend date is two days before this and is the date by which you must exercise your options in order to be a shareholder of record on the dividend date. Holding options does not qualify as shareholding, so long call options may be exercised early to be paid a dividend. One long call option entitles the owner to 100 shares of stock (in most cases), so the dividend is multiplied by 100 per option contract. In the case of regular dividends, the price of the stock is adjusted down by the price of the dividend on the ex-date, but the option strikes are not adjusted. So, if you own 1 share of stock XXX trading $100, on the day after the dividend you will have $1 plus one share of $99 stock. Regular dividends are one of the factors determining option price. Calls in an expiration month before a dividend will be trading a little cheaper and puts a little more expensive to take into account the dividend. Call value = intrinsic value + interest rate value + volatility value – dividend value. (Natenburg, Option Volatility and Pricing, p. 243.)*
If you are long in-the-money calls, you may need to exercise your calls early in order to avoid a loss. Calls should usually only be exercised if they are 100 delta and trading at parity. For example say a stock is trading $50 and announces a $1 dividend with an ex-dividend date of December 12th. And say you own the Dec 40 call. This call is trading around $9.75 at $10.25. So it’s worth $10. If you do nothing on the 12th, you wake up the next morning with stock $49. You still have the 40 call but now it is only worth $9 so you’ve lost the value of the dividend. By exercising, you would wake up with one dollar and one share of $49 stock, so you are even. Floor traders count on you not paying attention and not exercising your options early. This is something we will discuss below.
This year because of the threat of tax changes with the fiscal cliff, companies have been going dividend wild: increasing their dividends, moving them up if they were after the new year and announcing special dividends. A special dividend is a non-ordinary dividend and often implies an option strike adjustment. For more on this, I present to you part of OCC infomemo # 30412:
“Ordinary” cash dividends do not call for adjustments. An “ordinary” cash dividend is defined as one paid “pursuant to a policy or practice of paying such dividend on a quarterly or other regular basis”. A cash dividend which is considered to be outside this regular policy is non-ordinary. Assuming a given dividend is non-ordinary according to this definition, a size test is also imposed: the value of the dividend must be at least $12.50 per option contract. Thus, if the dividend is non-ordinary and yields at least $12.50 per option contract, then an adjustment will be made.
To note here is that because option contracts are good for 100 shares of stock, a dividend of greater than or equal to $.125 per share would qualify. The decision to adjust is made on a case by case basis, so it is always important to check with the OCC if you are at all unsure or if the situation is at all questionable. Let’s take the example from above with a special dividend of $1. In this case on the ex-dividend date the stock will be $49 and you will own the Dec 39 call which should be worth the same as yesterday. So all will be as it should be and you don’t need to early exercise. The OCC explains the rational for this:
In general, dividends declared pursuant to a policy or practice of a company can be anticipated and priced into option premiums according to standard models. Non-ordinary dividends declared outside the normal policy of the company cannot be anticipated and integrated into pricing with the same degree of assurance. Thus, when such dividends are announced, if no adjustment is made, the only way a call holder can capture the dividend is through exercise prior to the ex-dividend date. When this happens, significant option time value can be lost and financial losses due to operational error in submitting exercises may occur. The intention is to allow such dividends to accrue to the benefit of call holders without requiring them to exercise their options.
A dividend play is a strategy used usually by market makers and floor traders who have very low or capped commission costs. You may notice that a stock has an unusually high option volume and when you pull it up you see that tomorrow is the ex-dividend date. Let’s take for example Starwood Hotels (HOT) which I pulled up based on unusual volume. On the 11th, it closed at $53.96.
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You’ll notice the volume is primarily in the calls. HOT has a dividend of $1.25 per share with an ex-date December 12th. Even though this dividend is 150% higher than last year’s, because HOT regularly gives dividends, it is not considered a special dividend and the option strikes will not adjust. Looking at the options, you’ll notice the big prints are in the deep in-the-money Jan calls.
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Traders look for deep in-the-money lines that are 100 delta and trading parity and have some open interest. Because Jan options are around for a long time as leaps, often they will have a lot of in-the-money lines that everyone has forgotten about because stock has moved. Traders will then essentially swap large quantities of these options with each other. They will exercise their options and then, because the clearing firms assignment process is random, will hope they don’t get assigned on some of their thousands of short options and will get the price of the dividend for each share not assigned. Essentially they bank on the fact that whoever owned those calls has forgotten about them or isn’t paying attention.
So make sure you exercise your deep in-the-money calls if it is called for the afternoon before the ex-dividend date! Pay attention to dividend announcements and ex-dates and check the dates from at least two independent sources!
*There are some stocks, particularly foreign, that irregularly announce big dividends. If you see reversals and conversions trading out of line as if there is a dividend, but you can’t find any announcement of a dividend, you may need to be careful. Telecomunicacoes de Sao Paulo (VIV) is one of these:
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