Dividends and Option Pricing

Dividend Basics Let’s start at the beginning. When a company decides to pay a dividend, there are four important dates the trader must be aware of:1. Declaration date 2. Ex-dividend date3. Record date 4. Payable date The first date chronologically is the declaration date. This date is when the company formally declares the dividend. It’s when the company lets its shareholders know when and in what amount it will pay the dividend. Active traders, however, may buy and sell the same stock over and over again.

How does the corporation know exactly who collects the dividend when it is opening up its coffers? Dividends are paid to shareholders of record who are on the company’s books as owning the stock at the opening of business on another important date: the record date. Anyone long the stock at this moment is entitled to the dividend. Anyone with a short stock position on the opening bell on the record date is required to make payment in the amount of the dividend.Because the process of stock settlement takes time, the important date is actually not the record date.

For all intents and purposes, the key date is two days before the record date. This is called the ex-dividend date, or the ex-date.Traders who have earned a dividend by holding a stock in their account on the morning of the ex-date have one more important date they need to know—the date they get paid. The date that the dividend is actually paid is called the payable date. The payable date can be a few weeks after the ex-date.Let’s walk through an example.

ABC Corporation announces on March 21 (the declaration date) that it will pay a 25-cent dividend to shareholders of record on April 3 (the record date), payable on April 23 (the payable date). This means market participants wishing to receive the dividend must own the stock on the open on April 1 (the ex-date). In practice,they must buy the stock before the closing bell rings on March 31 in order to have it for the open the next day.

This presents a potential quandary. If a trader only needs to have the stock on the open on the ex-date, why not buy the stock just before the close on the day before the ex-date, in this case March 31, and sell it the next morning after the open? Could this be an opportunity for riskless profit?Unfortunately, no. There are a couple of problems with that strategy.First, as far as the riskless part is concerned, stock prices can and often do change overnight.

Yesterday’s close and today’s open can sometimes be significantly different. When they are, it is referred to as a gap open.Whenever a stock is held (long or short),there is risk. The second problem with this strategy to earn riskless profit is with the profit part. On the ex-date, the opening stock price reflects the dividend. Say ABC is trading at $50 at the close on March 31.

If the market for the stock opens unchanged the next morning—that is, a zero net change on the day on—ABC will be trading at $49.75 ($50 minus the $0.25 dividend). Alas, the quest for riskless profit continues.The preceding discussion demonstrated how dividends affect stock traders.There’s one problem: we’re option traders! Option holders or writers do not receive or pay dividends, but that doesn’t mean dividends aren’t relevant to the pricing of these securities. Observe the behavior of a conversion or a reversal before and after an ex-dividend date.

Assuming the stock opens unchanged on the ex-date, the relationship of the price of the synthetic stock to the actual stock price will change. Let’s look at an example to explore why.At the close on the day before the ex-date of a stock paying a $0.25 dividend, a trader has an at-the-money (ATM) conversion. The stock is trading right at $50 per share. The 50 puts are worth 2.34, and the 50 calls are worth 2.48.

Before the ex-date, the trader is Long 100 shares at $50 Long one 50 put at 2.34 Short one 50 call at 2.48 Here, the trader is long the stock at $50 and short stock synthetically at $50.14—50 1 (2.48 2 2.34). The trader is synthetically short $0.14 over the price at which he is long the stock.Assume that the next morning the stock opens unchanged. Since this is the ex-date, that means the stock opens at $49.75—$0.25 lower than the previous day’s close.

The theoretical values of the options will change very little. The options will be something like 2.32 for the put and 2.46 for the call.After the ex-date, the trader is Long 100 shares at $49.75 Long one 50 put at 2.32 Short one 50 call at 2.46Each option is two cents lower. Why? The change in the option prices is due to theta. In this case, it’s $0.02 for each option. The synthetic stock is still short from an effective price of $50.14. With the stock at $49.75, the synthetic short price is now $0.39 over the stock. Incidentally, $0.39 is $0.25 more than the $0.14 difference before the ex-date.