A stock option provides the opportunity to buy (via calls) or sell (via puts) 100 shares of the underlying stock at a fixed price, the strike price, on or before the option expiration date. Dividends are distributions to shareholders of retained earnings, which are the accumulated profits of a company. Cash dividends reduce the total remaining equity of a company. Call options lose value and put options gain value on the ex-dividend date, which is when dividend-paying stock prices drop by the amount of the dividend per share.
A typical dividend-paying stock pays dividends quarterly. The annual dividend rate is declared by the company at the beginning of the fiscal year. Dividends are attractive to shareholders and therefore cause shares to trade at a higher price than if no dividend was paid. Stocks prices drop by the amount of the dividend per share when dividends are paid, and the drop occurs on the ex-dividend date, which is the first date that new shareholders are no longer eligible for the current dividend.
The relationship between an option’s strike price and the current price of the underlying stock is called moneyness. An In-the-money (ITM) call has a strike price below the underlying stock price. The bigger the gap, the deeper the call is ITM. An out-of-the-money (OTM) call’s strike price is above the stock price. Puts operate in the opposite fashion: an ITM put’s strike is above the stock price. A deep ITM option’s price will change by an amount about equal to the underlying stock’s price change, but deep OTM may not move at all.
The reason why a deep ITM call moves the same amount as the underlying stock is because most of the option’s value is intrinsic. Intrinsic call value arises because a call holder can exercise the option, buying 100 shares at the strike price. Since the strike price of a deep ITM call is well below the current stock price, the call holder has an immediate profit on the shares bought at strike. For deep ITM calls, intrinsic value dominates other factors, such as time until expiration or the stock’s volatility. Puts operate in an analogous fashion.
When a stock goes ex-dividend, its price will drop by the amount of the dividend per share. Only stockholders who owned the shares at the close of trading on the day before the ex-dividend date will receive the dividend, which is why the stock’s price drops on the ex-dividend date. Call holders do not receive dividends. The calls they own will usually drop in value on ex-dividend day because the underlying stock is now worth less. The amount of the price drop is greatest for deep ITM calls.
Puts are the mirror images of calls. On the ex-dividend date, a deep ITM put will gain value, up to the amount of the dividend per share. For example, assume that XYZ stock pays a quarterly dividend of $1 that goes ex-dividend on September 15. On the close of the previous day’s trading, the stock price was $45 and a put with a $55 strike price was selling for $10.50. On the ex-dividend date, the stock price opens at $44 per share and the put begins trading at $11.45. The put increased in price by $0.95, almost the full amount of dividend.Click here for reuse options!
Copyright 2019 Eric Bank, Freelance Writer