Friday, January 18, 2008

How Dividends Effect Option Pricing

There are four major factors that influence the price of an option:

1. The price of the underlying stock.
2. The strike price of the option.
3. The time remaining until option expiration.
4. The volatility of the underlying stock.

In addition, there are two minor factors:

5. The current risk-free interest rate.
6. The dividend rate of the underlying stock.

This article will explain how dividends effect the price of call and put options, and how we can use either covered calls (CC) or cash secured puts (CSP) to capture the dividend.

There are four major dates in the process of a company paying dividends:

1. Declaration date – This is the date on which the board of directors announces to shareholders and the market as a whole that the company will pay a dividend.

2. Ex-dividend date – On (or after) this date the security trades without its dividend. If you buy a dividend paying stock one day before the ex-dividend you will still get the dividend, but if you buy on the ex-dividend date, you won't get the dividend. Conversely, if you want to sell a stock and still receive a dividend that has been declared you need to sell on (or after) the ex-dividend day. The ex-date is the second business day before the date of record.

3. Date of record – This is the date on which the company looks at its records to see who the shareholders of the company are. An investor must be listed as a holder of record to ensure the right of a dividend payout.

4. Date of payment (payable date) – This is the date the company mails out the dividend to the holder of record. This date is generally a week or more after the date of record so that the company has sufficient time to ensure that it accurately pays all those who are entitled.

The Ex-Dividend date is the most important date in the dividend process. On this date the stock price is guaranteed to drop by the amount of the dividend. This tends to lower the call option premiums and raise the put option premiums. The larger the dividend the lower the price of the call option and the higher the price of the put option. This happens because as the stock price is lowered by the dividend, the call becomes less valuable and the put becomes more valuable.

For example, let's say a stock is trading at $25 and it pays a $2 annual dividend. In 6 months it would pay $1 in dividends and, if all else stayed the same, the stock would be worth $24. A 6 month 25 strike call option would then be out-of-the-money (OTM), whereas a 6 month 25 strike put option would be in-the-money (ITM). In anticipation of this adjustment the call premium would be lower and the put premium would be higher.

One way to capture the dividend is by establishing a covered call (CC) position just prior to Ex-Dividend date, as I did with BBT on 1/7. Another way is to sell a cash secured put (CSP), which has an identical risk profile and provides similar returns as CC's, if done at the same strike.

Let's look at the BBT covered call (CC) trade I established on 1/7 and compared it to doing a cash secured put (CSP). With the stock trading at $28.12 (ask) and the Feb 27.50 Call could be sold for $1.64 (bid) and the Feb 27.50 Put could be sold for $1.45 (bid). The Ex-Dividend date for BBT was 1/9, or two days after the position was established. BBT pays $1.84/year in dividends, or $0.46/quarter. The price of BBT on 1/9 was therefore reduced by $0.46.

Here's a summary of the CC position I established:

Summary without the dividend:

Stock Investment: $2,812.00
Income Generated: $164.00
Percent Income Generated: 5.83%
Annualized Income Generated: 54.58%
Net Profit If Called: $102.00
Percent Return If Called: 3.63%
Annualized Return If Called: 33.95%
Days to Expiration: 39 days

Summary with the dividend:

Stock Investment: $2,812.00
Income Generated: $210.00
Percent Income Generated: 7.47%
Annualized Income Generated: 69.89%
Net Profit If Called: $148.00
Percent Return If Called: 5.26%
Annualized Return If Called: 49.26%
Days to Expiration: 39 days

Here's a summary of a possible CSP position:

Cash to Secure Put: $2,750.00
Income Generated: $144.00
Percent Income Generated: 5.24%
Annualized Income Generated: 49.01%
Net Profit If Expired: $144.00
Percent Return If Expired: 5.24%
Annualized Return If Expired: 49.01%
Days to Expiration: 39 days

The CC position requires $2,812 in cash to be spent purchasing the stock, whereas the CSP position leaves the $2,750 in cash in the account to earn interest. Obviously, a CSP will generate more interest than a CC. This is important to understand when calculating your total return.

The returns above represents the profit if the call is assigned and the put expires worthless. The CC returns $102, without the dividend, and the CSP returns $144. Add in the dividend for the CC and the return is $148, which is $4 more than the CSP. However, when you add the interest (assuming 4% annual interest for 39 days) on the cash left in the account for both cases, the CSP comes out ahead at $156.64 vs $148.70 or 52.11% annualized vs 49.47% annualized.

So, given this example I would have been slightly better off doing a CSP vs a CC, since the dividend is already priced into the put premium and the interest earned on the extra cash left in the account makes it more profitable.

So, if you would like to accumulate shares of dividend paying stocks, then you might want to consider cash secured puts. If the put expires worthless you still get paid the dividend, in the form of added put premium, and if the put is assigned you buy the shares you wanted anyway but at a lower price.

Probably the best method is to compare both a covered call and a cash secured put position, as I did here, and chose the one with the greater return.