Options have been a favourite instrument amongst investors and speculators alike in hedging and protecting their market positions. When the ex-dividend date approaches, the stock is bound to fall. Factoring that in, is playing with options an easy way to speculate and make some quick money?
Below, we’ll explain what a call option is, what American and European options are and how premium prices move.
Stock Price Fall
Let’s assume the above date sequence for our example on call option pricing. The company declared on 2016-03-28 the stock would go ex-dividend on 2016-04-25. The amount of dividend is $0.44. So, it’s expected that the stock would fall by the amount of dividend on the ex-dividend date. For the investor to get his name in the record books and receive a dividend, he/she needs to buy the stock 3 days before the record date. That date falls one day before the ex-dividend date on 2016-04-24.
What Is a Call Option?
A call option, as the name suggests, is an “option” to buy stock at a specified price, up until a specified date. In order to receive this option, one has to pay a premium. For example: An investor wants the option to Buy ABC Inc at $100 (strike price) and buys a 1 month contract on January 1, 2016 that expires on January 31, 2016. He pays a premium of $3 to buy this option to the option seller.
On the expiry date, if the price of ABC is $110 then the buyer of the call option will profit by $7 since he has the option to buy the shares at $100, but paid $3 to buy it. The investor can always exercise the option before expiry date if he/she is already in profit.
On the expiry date, if the price of ABC is $90 then the buyer of the call option will be in loss since he/she has the right to buy ABC at a price that is above the current market price.
Call Option Pricing and Ex-Dividend Date
A call option essentially rises in price when the stock price rises and falls in price when the stock falls. A call option is an option to buy 100 shares of the stock at a strike price up to the expiration date. The buyer of the call option pays a premium to the seller of the call option to purchase this right. Options can be American or European. American options can be exercised before the expiration date while European options can be exercised only on the expiration date. The difference in both these structures makes American options more expensive than European options. Most options in the US are American.
From the date the dividend is declared, the call option price will start falling right up to the ex-dividend date due to the anticipated drop in price. If the buyer of the call option is in the money, then he can sell the call option and collect the dividend. The seller of the option will deliver the stock to the buyer of the call option.
The bottom line is that call option prices start adjusting themselves in anticipation of the drop. They don’t fall down suddenly when the stock goes ex-dividend.
Put options have the exact opposite effect when stocks go ex-dividend where they rise in price as the stock is anticipated to go down in price. A detailed analysis of put options and the ex-dividend date will follow soon.