March 17, 2005

The Dividend Effect:
How Stock and Option Prices React to Dividends
by John Brasher, CallWriter Publisher

There seems to be a lot of confusion among traders as to the effects cash dividends have on stock prices and option premiums. These effects are easy to grasp once you understand why they happen, since it is all common-sense based. The covered call writer needs to get a handle on dividends if planning to hold and write stocks through the ex-dividend date.

Dividend Fundamentals

Most mature public companies pay a cash dividend to shareholders. This article will explore what effects dividends have upon stock prices, call prices and put prices, as well as how dividends affect covered call writers in particular. For an explanation of how dividends work, please see our detailed newsletter article on Dividend Basics. A dividend actually is a distribution to a company's owners (stockholders) of a part of the company's earnings. The company's board of directors must authorize (declare) payment of the dividend. When the dividend is declared, the company will announce the record date, which is the date the company will determine who is a shareholder of record, and the payment date. Here is the chain of events for each dividend:

Significance of the Ex-Dividend Date

The ex-date is always two business days before the record date. For example, if the record date for the dividend is Friday the 16th, the ex-date will be the preceding Wednesday, the 14th. In order to get the dividend, you must buy the stock before the ex-dividend date.  Before the ex-date, the stock is said to trade "with dividend," because buyers of the stock will receive the dividend. On and after the ex-date, the buyer will not receive the dividend and the stock is said to trade "without dividend." We all know that stocks offer high covered call returns when some impending event drives call premiums high. Sometimes stocks soon to pay a dividend offer high enough premium to hit CallWriter's Real Time Lists™ of the highest-returning covered call trades. The question becomes, how should covered writers approach dividend stocks?

Dividend Effects on Stock Price

Wall Street rarely gives money away, and that's as true of dividends as anything else. For this reason, once the dividend has been announced, the market prices it into the stock. If a company should announce a $1.00 per share quarterly dividend, the market will add that $1.00 into the stock price. For example a $19 stock would usually jump to $20 or so, unless the dividend was considered to already have been priced in. Thus if you buy the stock after the dividend is announced, you will not receive a "free" dividend. You will have paid for the impending dividend in the stock's price. When a stock goes ex-dividend, on the other hand, the stock price will be driven downward because the dividend payment reflects a distribution of corporate assets, and thus some of the share's value. The stock simply is not worth as much once the stock trades without dividend.

The amount the stock price will decline on the ex-date cannot be ascertained exactly in advance. Some research indicates that the stock price falls in an amount equal to the dividend, other research that it falls but by an amount less than the dividend paid. But the stock will almost certainly fall on the ex-date, and you should figure on a drop in roughly the amount of the per-share dividend. Since one purchasing a stock on or after the ex-date does not receive the dividend, no one would rationally pay the same price on or after the ex-date as paid before the ex-date. That is, the market prices the dividend in before the ex-date and prices it out on the ex-date. Whatever the amount, whether all or only a portion of the dividend, the stock will fall on the ex-date. If you buy the stock after the dividend announcement, you must hold the stock until at least the ex-date so that you receive the dividend. Otherwise, you pay for the dividend priced into the stock but don't receive the dividend!

Below I will discuss the effect of dividends on different covered call writes. First, though, it is helpful to look at dividend effects on call and put premium.

Dividend Effects on Call Premium

The market does not price the dividend into the call premium, as happens with the stock, because the call buyer does not get the dividend. Only holders of stock before the ex-date get dividends. In fact, the call price should be discounted to some extent for the dividend, since the underlying can be expected to fall by the entire amount (or a respectable portion) of the dividend. Why would a call buyer pay a big premium based on an impending dividend when (1) the holder of the call doesn't receive the dividend in the first place, and (2) the underlying will fall by all or most of the amount of the dividend? No one would.

However, since the underlying dividend stock's price will drop on the ex-date, the prices of the calls on the stock will drop at that time, also. Note that the fall in the call's price is directly related to the movement of the stock's price and the call's strike price, not the dividend. Cash dividends therefore do not affect option prices directly but through their effect on the underlying stock price. Because the stock price is expected to drop by all or a large part of the amount of the dividend on the ex-date, high cash dividends imply lower call premiums and higher put premiums. Here is the general rule:

Covered call writers should pay attention to this and keep it in mind. Low-volatility stocks are excellent for covered writing, but the ones paying high dividends usually won't offer much premium. To get high premium on a stock with impending dividend, the stock usually is one with high volatility - and high volatility plus the expected price drop on ex-date means the calls written had best be solidly ITM.

How much call premium will fall on the ex-date depends on the amount the stock price drops and where the call's strike price is in relation to the stock price; that is, whether the strike is ITM, ATM or OTM. The ITM call premium can be expected to drop dollar-for-dollar with the stock. In fact, where the premium includes a high amount of time value due to a high level of implied volatility, the drop in premium can be even greater than dollar-for-dollar. If the ITM call's premium is high enough to place it on CallWriter's Real Time Lists™ (it sometimes happens), then the premium's time value component is relatively high, and implied volatility is high. The ATM call premium will drop, but generally by an amount less than the drop in the stock price. In fact, the drop may not be that great, because as the stock price falls, the ATM call becomes increasingly out of the money. The OTM call premium, which is all time value, frequently will drop the least, although the percentage of the drop may be the highest. Calls that are deeply OTM will not be very affected, but for the reasons outlined in the above Covered Calls and Dividend-Paying Stocks table, there will rarely be any reason to write OTM calls on stocks with impending dividends.

Trade Tip:  When writing calls with high premium on a stock that has announced a dividend, be sure to check the news. Since the fact of an impending dividend does not of itself cause call premium returns to soar, the high premium could indicate an unrelated piece of news pending. As with any trade, do the requisite analysis.

Dividend Effects on Put Premium

Dividends are in effect priced into in-the-money put premiums, since the underlying stock is expected to fall by roughly the dividend amount on the ex-date. Puts on stocks about to pay dividends are more valuable precisely because of the expected drop in the underlying. All or a good part of the dividend amount may be priced into puts, since the market does not like to give money away. Otherwise, traders would buy puts in huge numbers and collect huge profits when the stock takes the expected drop. The higher the cash dividend, therefore, the higher the put premium will be, and the smaller the dividend, the smaller the put premium.

For these reasons, buying puts does not work. As with calls, the dividend effect on put premium depends on whether the put is ITM, ATM or OTM. The dividend should not be fully priced into the OTM put, and may not be priced in at all. The dividend will be pretty much fully priced into the ITM put, and perhaps also the ATM put. Thus in our XYZ example above, I would expect a price of $1.00 or more for the 20 Put, and I would expect the price of the ITM put strikes above $20 to include the $1.00 dividend amount, since the stock is expected to drop by as much as the $1.00 dividend. For this reason, buying ATM and ITM puts on a stock about to pay a dividend is usually fruitless. Buying the OTM put is seldom productive, either, since it is too far out of the action and may not increase much at all upon the ex-date drop in the stock.

What about writing naked puts? Selling an ATM or ITM put naked in this situation is a very poor strategy, because you know in advance that the stock will drop, putting you in jeopardy of having the stock put to you. And since the drop in stock price only increases the value of the ATM and ITM puts, it would cost more to buy back the puts on or after the ex-date, in order to avoid assignment, than is received upon selling them. Selling the OTM put naked can work (in our XYZ example above, selling the 17.50 Put) if you guess right that the stock will pull back no further than the $19 price level. In this example, however, I would not expect the XYZ 17.50 Put to carry very much premium, precisely because it is never expected to be "in play."

Dividends and Covered Calls

Writing covered calls on stocks with impending dividends is therefore not really a strategy, because the market doesn't give dividends away. If you have bought a stock and written a covered call on it after the dividend announcement, early assignment does not matter, since you will get the strike price. But suppose the call writer is not called out in this situation? Dividend stocks can be fine candidates for covered calls, but you have to think through the amount of the call premium and the stock's likely price adjustment on the ex-date. The table below illustrates some likely outcomes of writing different strike covered calls on a stock with an impending dividend.

Example:  Let's consider below the effects of writing different strike calls on hypothetical XYZ stock. Assume that XYZ 's board has announced a $1.00 quarterly dividend, causing the stock to jump from $19 to $20. If you write covered calls on XYZ, you will pay $20 for the stock. While few stocks pay a dividend with such a yield (but see FRO), the dividend makes the discussion easier to grasp.

Obviously, not every stock carries a 20% dividend yield (annual divided ÷ stock price) like our hypothetical XYZ. For a stock paying a $0.25 quarterly dividend, the effects after the dividend announcement and on the ex-date are not nearly so dramatic as in the XYZ example. But the effect still will be there. The above discussion assumes that the covered call writer is a systematic writer, meaning one who buys stocks for the purpose of writing calls on them, as opposed to one who writes calls on long-term portfolio stocks.

The portfolio writer has a different perspective, however, since he would not buy XYZ just to write calls on it but would hold it long term for the dividend yield (stocks with high dividend yields are not usually growth stocks). The first and foremost goal in owning the portfolio stock is not to get called out, remember. TheOTM calls do make excellent sense for the portfolio writer, unlike the systematic writer. Why? For one thing, the stock already is in the portfolio and was not purchased with the current dividend priced in. The portfolio writer therefore receives the quarterly dividend and also rakes in the OTM call premium, yet the stock price drop on ex-date makes it extremely unlikely the OTM calls will be exercised. The ATM call might work just as well for the portfolio writer, and the premium will be larger than for OTM calls, but there is more risk of being called out of the stock than with the OTM. The ITM call is a poor choice for the portfolio writer, since there is high risk of being called out.

Early Exercise of Calls

Whoever owns the stock as of the ex-dividend date receives the cash dividend, so holders of ITM calls may exercise them early to capture the cash dividend. That means early exercise of a call makes sense - and is likely - only if the stock is expected to pay a dividend prior to expiration date. Thus if you write calls on an impending dividend stock whose ex-date is prior to the expiration date , you are more likely to be assigned an early exercise than normal. If the time value is gone from the call, early exercise becomes very likely.

Question:  Can covered calls really be profitably written in a dropping market?

Answer:   Sure they can, depending on the market's condition at the time. Your question is akin to asking whether it is possible to drive when it is snowing. In a light snow, certainly you can, and we do it all the time, but not in a blizzard. More information is required to answer the question. How heavy is the snow, is the snow sticking to the roads, and is the amount of snow falling expected to increase or decrease? For that matter, what condition are the roads in, what vehicle are you driving, are you experienced in snow, how far are you driving? You get the picture.

Writing calls in a dropping market imports a similar analysis. Markets don't advance or decline at a steady rate. They are instead characterized by sharp movements, gradual advances or declines, and consolidation periods when the market ranges. In a sharply dropping or collapsing market phase, you should never write covered calls and should be either closing or rolling down open covered call positions. Most covered call articles and books state, almost as a mantra, that you only write covered calls in bull and perhaps neutral markets, but never bear markets. But I have learned that simply is not true except in the worst parts of a decline. There are two factors that make it possible to write in most bear markets:

Good luck and good trading!