Dividend Risk When Trading Options

Can someone explain dividend risk please

Greg

In options terminology, 'dividend risk' refers to the chances of not collecting the dividend when you have written a covered call.

If you own stock and want to collect the dividend, and if you also want to write covered calls that are slightly in the money, then you may encounter dividend risk.

When the stock rallies before the stock goes ex-dividend, sometimes that dividend is large enough to encourage the call owner to exercise the option, one day before the stock goes ex-dividend.  When that happens, you are obligated to sell your stock and thus, fail to collect the dividend.

Not all options are exercised for the dividend.  Obviously the option must be a call and not a put, and must be in the money – or there's no chance it will be exercised (barring a very unusual mistake by the option owner).  But being ITM is not sufficient reason to exercise.  Why?

The exerciser now owns stock instead of calls.  Thus, the proud owner of the stock, and its dividend, now has downside risk,  That's  the risk of losing money if the stock declines below the strike price of the call (which no longer exists).  When that happens the exerciser loses more money (when owning stock) than he/she would have lost owning the call.  That possibility makes the decision to collect the dividend a difficult choice.

The careful call owner only exercises when two things are true:  the stock has zero time value and the delta is 100. 

For readers who are less experienced in the finer points of options, here's an easier way to understand the explanation:  The perceived risk that the stock will dip below the strike price must be low enough for the call owner to take that chance – in return for the dividend.  In practical terms, this often means the corresponding (same strike and expiration date as the call) put can be bought for less than the dividend; and b) the cost to own the stock from exercise date through expiration (interest not earned on the cash used to pay for the shares) is less than the dividend.

To clarify:  The sum of a) an b) must be less than the dividend

If you have a copy of the Rookie's Guide to Options, there's a thorough discussion on pp 92-93.

313

8 Responses to Dividend Risk When Trading Options

  1. Gil 04/26/2009 at 7:48 PM #

    Search/Scan tools for the rookies
    ==================================
    Good week Mark,
    A general question:
    Other than the general indexes which you’re used to trade (^RUT), do you use any free tools for retrieving which sector/index/holdr/etf/stocks etc. to look into?
    Thanks
    Gil

  2. Mark Wolfinger 04/27/2009 at 9:51 AM #

    Hi Gil,
    I don’t. But that’s because I take the general view that people cannot predict market direction on a consistent basis. And thus, I don’t care about prognostication – either from technical or fundamental data.
    However, I do know that some people do earn a good living my forecasting market direction. At this stage of my trading career, I must confess that I am not interested in making a vast chance to what I do.

  3. kbluck 04/27/2009 at 10:18 AM #

    I’m sure you know this, but you didn’t mention that it can get even worse for the equity iron condor trader than merely not collecting a dividend. Iron condor traders are often short calls when ex-dividend comes around, and usually have no long position in the underlying. If those calls should be exercised, you will suddenly be short the underlying. Now, not only are you at risk from having an unhedged short stock position, and very possibly facing a margin call, but because you are short that stock as of ex-dividend you actually *owe* a dividend payment which must eventually be paid by you in cash. Highly unpleasant.
    Another good reason to trade index options.

  4. Mark Wolfinger 04/27/2009 at 11:26 AM #

    I don’t agree with some of your conclusions.
    1) I see no added risk when short the underlying stock. Because it’s an iron condor position, you are long a call, presumable OTM, as a hedge against the stock. That’s the equivalent of owning a naked long put. Yes, it may cost you the dividend, but the IC trader now has an unlimited theoretical gain to the downside. To me that’s reduced risk.
    2) If your broker doesn’t recognize long call/short stock as a hedge, you need a new broker. But, even if they don’t, no one should carry a position for which there would be a margin call when assigned on any option.
    3) But I do agree: trading cash-settled index options avoids any such situation. And if you consider it to be ‘highly unpleasant,’ that’s all that matters. TYou can easily avoid this unpleasant situation by using index options.

  5. kbluck 04/27/2009 at 12:03 PM #

    You are of course right about the long call hedge; I shouldn’t have called the short stock “unhedged”. But that assumes you’re allowed the choice of holding the short stock until a time of your own choosing.
    I would imagine that most of your audience has RegT margin rules, since portfolio margin doesn’t kick in until at least 100k for most brokers, even sophisticated brokers like ToS or IB. I could be wrong, but I believe RegT rules are quite inflexible on the issue of stock margin, option hedges notwithstanding. Brokers have to toe the line.
    Let’s imagine a not unlikely scenario: some small trader with a $10k account. Perhaps he’s trading a 5-lot 1-strike wide DIA IC with let’s say $500 at risk per lot after credit. That’s about $2,500 in net margin for the position, perhaps aggressive but not outlandishly so if its money he can afford to lose. But if assigned, suddenly being short 500 shares of DIA worth $40k is a RegT margin call that may be liquidated at an unfavorable price on open.
    Not devastating, but certainly more than he needed to lose if he’d been on the ball and closed out his call leg the prior day. Just one more thing beginners (or inattentive veterans!) need to keep in mind when they decide to hold into expiration. A corollary moral here is: don’t trade instruments you don’t understand, and for stocks or ETFs that includes knowing the next ex-dividend date.

  6. Mark Wolfinger 04/27/2009 at 12:38 PM #

    Yes, RegT rules cannot be ignored.
    Yes, never trade a product you don’t understand and yes, be aware of all ex-dividend dates.
    I’d like to add one more to the moral: don’t hold through expiration. As strongly as I believe in that advice, I recognize that most investors don’t see it that way.
    But you and I are in agreement that the safest course is to trade those cash-settled index options. Still. some prefer to trade individual stocks and the ability to meet a margin call must be considered.
    And that goes back to the ofiginal post. If anyone writes cash-secured puts, then there is no worry about a potential margin call. By definition, a cash-sercured put is safe from a margin call.
    And that’s why selling ‘too many’ put spreads instead of fewer cash secured puts, is a poor idea.

  7. kbluck 04/27/2009 at 12:56 PM #

    D’oh! I screwed up the margin math. It’s <$500 at risk total, not per lot.

  8. Mark Wolfinger 04/27/2009 at 1:00 PM #

    The point is that a customer must be aware of RegT margin requirements – just in case he/she is assigned an exercise notice.