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Option Calls Holders: Don’t Get Pinched By Ex-Dividend Risk

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October 29, 2015
Option Calls Holders: Don’t Get Pinched By Ex-Dividend Risk

Ex-dividend risk refers to the potential loss that traders face when they fail to exercise long option calls on dividend-paying stocks. Collectively, traders who misunderstand this risk—or don’t know how to avoid it—needlessly wave buh-bye to beaucoup bucks market-wide every time a stock goes ex-dividend.

But before understanding ex-dividend risk, you must first grasp how dividends affect stock prices. This isn’t a lofty discussion about whether companies that pay dividends are better than those that don’t. But simply, a question: What happens to a stock’s price once it trades without the dividend?

For the Record

Let’s start with company XYZ paying a $0.50 per-share dividend. Who gets it? Shareholders of record, of course, which means that you have to buy the stock and go through the three-day settlement period before the company considers you on that record. But there can also come a day when the stock starts trading “excluding the dividend.” This is called the ex-dividend day, or sometimes ex-div for short. This is an important date for option traders to know.

Let’s assume XYZ shares are trading at $50 on Monday, and Tuesday is ex-div day. On Tuesday morning, assuming the stock opens unchanged on the day it’ll actually be trading at $49.50 a share. This looks like a 50-cent price drop for no apparent reason and for the stock owner it’s no big deal. There’s a dividend payment coming and that’ll make up that short-term blip.

But what about the trader who owns call options, specifically deep in the money (ITM) options? As an example, assume the 40-strike call on Monday is deep enough ITM and close enough to expiration that it’s pretty much a 100 delta call. That means that it moves penny for penny with the stock price.

So on Tuesday when the stock goes ex-dividend and is worth 50 cents less, these calls are also going to be worth 50 cents less. This also looks like a price decline. And guess what? It is. There’s no dividend payment coming to make up that dip.

This dip can easily be masked by market movement. For instance, what if the stock goes to $52? Then it’ll look like both the stock and the 40-call option prices have both gone up by $2. But the stock owner gets the dividend while the option owner does not. Some traders might just be happy to have a $2 price increase, but in the financial world this is still a needless option loss regardless of how you sugarcoat it. No matter where the stock moves on Tuesday, call option owners won't get the dividend like straight-up stock owners.

Thinking Exercise?

That dividend may eventually entice some option holders. By exercising the call and becoming a shareholder of record who’s entitled to the dividend. In order to have this status, though, you need to exercise your call option the day before ex-dividend day and actually purchase the shares of stock at the strike price of the option. If you wait until the ex-div day, you’re too late and will end up buying the stock excluding the dividend.

Keep in mind that call holders paid a premium for the option, then paid the strike price to own the stock, plus transaction costs and exercise fees. This obligation can require a lot of capital to get a dividend that may not be significant compared to the cash outlay.

One issue you might see with buying the stock is that now you’re on the hook for all of the risk that comes with buying stock. What if the stock craters?

Now, one strategy is to sell the call before ex-div. Or, you might employ a new strategy that potentially limits some of that risk. One potential fix is to buy a put option at the same strike as the call that you’re exercising. That limits the risk to the same amount you had by owning the deep ITM call, excluding transaction costs.

There’s still risk, of course. But by owning the stock, you now avoid the loss taken by so many option traders who are caught flat-footed on ex-div.

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