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Swim Lessons: Keep An Eye Out For Dividend Risks With ETF Call Options

June 8, 2017
Swim Lessons: Keep An Eye Out For Dividend Risks With ETF Call Options

Experienced options traders know that, if you routinely sell call options short—either by themselves or as part of a strategy, like covered calls— eventually you’ll likely wake up one day to find you’d been assigned ahead of the call’s expiration date. Remember: short, American-style options can be assigned at any time prior to expiration regardless of the in-the-money amount. However, most early assignments don’t happen until the week of expiration.

The following, like all of our strategy discussions, is strictly for educational purposes only.  It is not, and should not be considered, individualized advice or a recommendation. Options trading involves unique risks and is not suitable for all investors.

Almost without exception, the call you got assigned was in-the-money (ITM). But just because a call goes ITM doesn’t mean it’s going to get assigned. There’s actually some reasoning behind early assignment, and some of it has to do with dividends.

For the basics on dividend risk, please refer to this recent primer. In a nutshell it comes down to this: stock and ETF owners will receive the dividend, assuming they owned the stock (or ETF) prior to the ex-dividend date. Call option owners, however, do not receive the dividend.

It’s important to understand this difference because dividend risk appears frequently—typically once per quarter for US companies and ETFs that pay dividends. For instance, the SPDR S&P 500 ETF (SPY) goes ex-dividend on June 16th.

With dividends from the corporate world it’s relatively easy to know what the dividend amount is going to be, and when, because they tell us far in advance. With ETFs, however, which can represent the stocks of many companies in one product, it’s not always so easy. The actual dividend amount may not be known until just before the ex-dividend date. But that doesn’t necessarily mean we can’t plan for it. We can, and we can generally do that by using the ITM puts.

How deep ITM? Using the options that expire June 16, look at the puts whose corresponding calls are offered at $0.01. These calls have no extrinsic value, and put-call parity says the puts shouldn’t have any extrinsic value either. But in figure 1 we can see that those puts are trading with about an extra $1.00 - $1.07 above their intrinsic values. While it’s not an exact science, and there’s no guarantee, one can infer that the market is expecting a dividend of about that amount. Of course, the actual SPY dividend may differ, but this is a method that a lot of traders rely on to estimate the dividend amount when it hasn’t yet been announced.

SPY Options Chain


The option chain for SPY showing the extrinsic value of deep ITM puts that expire June 16. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Based on this amount, we can start to get an idea of which call options are likely going to be exercised by their owners. Good candidates for early exercise would include any ITM call with an extrinsic value of about $1.00-$1.07 or less. Why? Holders of these call options would be better off foregoing the remaining extrinsic value of the call in favor of the dividend.

This, in turn, can give a heads-up to those who are short those call options – assuming they understand dividend risk – that they may very well wake up on June 15th to find they’ve been assigned. 

What do you do if you’re long or short any of these exercise candidates? If you’re long a call, you could exercise your call, thus giving you the right to the dividend. Or roll out to a strike that is not an exercise candidate.

You might not want to hang on to the call, as it will likely lose value when the stock goes ex-dividend, without getting the dividend payment to offset it. And if you’re short, you can also look to roll out to another call that’s not an exercise candidate.

Want more on dividend risk? Join Swim Lessons on June 14, 2017 at 10:30 AM CT as Kevin Hincks and I dive in further.

TD Ameritrade clients can join Swim Lessons by launching thinkorswim®,  and navigating to Support/Chat > Chat Rooms > Swim Lessons > Watch.

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