Call options and put options have been a favorite for investors and speculators alike to hedge their portfolios or to make some quick money off stock price movements respectively. A layman or a new investor might get overwhelmed by the complexity of these instruments. But if they are understood properly, one can play special dividend announcements or even ‘big payout’ ex-dividend dates anticipating a drop in share price by buying put options.
Below Dividend.com explains what American and European put options mean and how you can profit by playing in put options.
Stock Price Fall
Let’s assume the same ex-dividend dates we assumed for the call options and the ex-dividend date analysis. Company ABC Inc. declared a dividend on 2016-03-28 amounting to $0.4410 that has an ex-dividend date of 2016-04-25.
All investors whose names appear on the books of the company as of 2016-04-27 will get the dividend, which will be paid on 2016-05-12. For that to happen, investors/speculators need to buy the stock on 2016-04-24.
What Is a Put Option
A put option, as the name suggests, is an ‘option’ to sell the stock at a specified strike price up until a certain date. For example: An investor wants the option to sell 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 $90 then the buyer of the put option will profit by $7 since he has the option to sell 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 $110 then the buyer of the put option will be in loss since he/she has the right to sell ABC at a price that is below the current market price.
Put options are the exact opposite to call options. The buyer of a call option benefits when the stock price rises above the strike price, while the seller of the call option loses. The buyer of the put option benefits when the stock price falls below the strike price, while the seller of the put option benefits when the stock price stays above the strike price.
Put Option Pricing and Ex-Dividend Date
A put option buyer pays a premium to the put option seller to purchase an option to sell the stock at a specified strike price up to the expiration date. Options can be European options or American options. American options can be exercised before the expiration date, while European options can only be exercised on the expiration date. The added feature of selling before the expiry date for American options makes them more expensive than European options. Most options in the US are American.
From the date the dividend is declared, right up to the ex-dividend date, the price of the put option will start rising in anticipation of a fall in price, while the price of the call option will start falling. When it’s said that the price of a call option/put option rises/falls, it’s actually the premium associated with the the options that is rising or falling.
On the ex-dividend date, the stock price abruptly falls by the amount of the dividend. However, don’t expect such a sharp price movement in their option premiums on the same day. They adjust themselves as soon as the payout announcement is made. Call option premiums would start to fall steadily, while put option premiums would start to rise steadily.
Find an analysis of call options and the ex-dividend date here.