Long call option traders avoid ex-dividend stock inequality by exercising the call and becoming a shareholder of record. Just watch timing and new stock 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?
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.
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.
The calendar tool on the thinkorswim® platform features corporate announcements including earnings, splits, dividends, and more, shown in figure 1.
Log in to your account, then go to MarketWatch > Calendar and select how you’d like to populate your calendar view. Clicking on the dividend icon opens more details, including the ex-div date. For illustrative purposes only.
FIGURE 1: NEW-LOOK THINKORSWIM® PLATFORM
Set only the alerts you want to see using the calendar tool on the thinkorswim® platform. For illustrative purposes only.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2019 TD Ameritrade.