Learn about dividend risk, which options might be candidates for early exercise, and how you can potentially prepare for it.
So you've got an options strategy in a stock or exchange-traded fund (ETF)—say a covered call, a naked call option, or even a multiple-leg strategy like a call vertical spread—that's humming along, and all of a sudden you receive notice that one leg, likely a short in-the-money call, has been assigned. Worse yet, it's happened right before the ex-dividend date.
Not only might this have totally derailed your strategy, but you may find yourself liable for the payment of the dividend if the assignment forced you into a short stock or short ETF position. Or, if you held stock against the position, your stock may have been called away just before you were to receive your dividend. Zowie!
It's called dividend risk, and it can and does happen. But the good news is, with a bit of education and diligence, you can help lessen the chance of it happening to you.
Many publicly held companies pay periodic dividends—generally quarterly—to shareholders of record as of a certain date, called the "record date." In general, in the U.S., standard stock options and options on exchange-traded funds (ETFs) are American-style options, meaning they can be exercised at any time before expiration.
So which calls might be good candidates for early exercise? The answer lies in an option's extrinsic value, also known as its "time value" or “time premium.” Remember, an option price is made up of two components: intrinsic value—the amount by which an option is in the money—and extrinsic value, or the value over and above its intrinsic value, based on the amount of time until expiration and the implied volatility of the stock or ETF.
Put yourself in the shoes of the owner of an in-the-money call on a stock that's about to go ex-dividend. Should you exercise the call to receive the dividend? That depends. When you exercise a call, you're essentially swapping the call for the underlying stock, at the strike price, and forgoing any remaining extrinsic value in that call. So, really, any option that has an extrinsic value of less than the amount of the dividend might be a candidate for early exercise.
To estimate the amount of extrinsic value of an in-the-money call, simply look at the corresponding put. According to put-call parity, a put and a call of the same strike and expiration date will have the same amount of extrinsic value. Figure 1 below shows an example with explanation. If you have questions about put-call parity, intrinsic and extrinsic value, or the math behind option pricing, please refer to this primer.
FIGURE 1: INTRINSIC AND EXTRINSIC VALUE.
In this sample option chain, with the stock trading at 74.93, the 74-strike call has $0.93 of intrinsic value. The midpoint of the 74-strike call’s bid/ask is $1.09, $0.16 above its intrinsic value. The midpoint in the 74-strike put is also $0.16. Image source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
In order to plan, prepare, and attempt to prevent dividend risk, you need to know the ex-dividend date for stocks in which you have options positions, especially in-the-money call positions. To view ex-dividend dates in the thinkorswim® platform from TD Ameritrade, under the MarketWatch tab, click Calendar and check the boxes for Dividend and ETF Dividend Dist. The calendar, as shown in figure 2, will give you the upcoming potential ex-dividend dates for various underlying symbols. Double-click on any name to see the amount and other details.
FIGURE 2: EX-DIVIDEND DATE CALENDAR.
Under MarketWatch > Calendar, click Dividend and ETF Dividend Dist to pull up the dividend information. Image source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
But it's important to note that the information in the platform isn't "official," so to be on the safe side, you may wish to double-check the company's investor relations page to verify.
And remember: short 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.
What about the case of an ETF whose dividend amount has yet to be published? Although there's no guarantee, there is a widely used industry standard used by many traders to estimate the expected amount—or at least the amount priced into the current market. And to do it, we'll be revisiting intrinsic and extrinsic value, but this time with a deep in-the-money put.
Suppose an ETF is trading for $200 a share, and we want to estimate the amount of a coming dividend. Pull up an option chain and look at a deep in-the-money put, preferably one in which the corresponding call has zero bid, which, if you recall from above, means that the strike has no extrinsic value.
Suppose we see from the option chain that the 208 puts have a current midpoint of $9.10, and the 208 calls are zero bid at $0.01. In this example, the put has an intrinsic value of (208–200) =$8, but at $9.10, the put is trading with an extra $1.10 over its intrinsic value. This extra $1.10 is an approximation of the expected dividend distribution.
FIGURE 3: APPROXIMATING AN EXPECTED ETF DIVIDEND.
The 208 put, deep in the money, is trading $1.10 over its intrinsic value and there is less than $0.01 of extrinsic value in the option. The extra $1.10 can be used as an approximation of the expected dividend distribution. For illustrative purposes only. Past performance does not guarantee future results.
So any short in-the-money calls in your position with an extrinsic value of less than $1.10 might be candidates for early exercise.
And if you find yourself with an early-exercise candidate? It may be time to liquidate or try to roll the position.
Dividend risk is triggered by upcoming dividends, which can set in motion an option's early assignment. Learn more about dividend risk by watching the short video below.
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