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Critical Facts You Need to Know About Preferred Stocks
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Dividends play a role in determining the price of an option, as the changes to a stock price will fluctuate ahead of a company’s ex-dividend date.
The impact of a dividend will be to increase the price of a stock ahead of the ex-dividend date as anyone who buys the stock will be entitled to receive a dividend. There are several factors that determine how the price of an option will react to the payment of a dividend, which include whether the option is a call or a put, if the option is in or out of the money, as well as the remaining time value of the option. While dividends do affect the price of an option, the impact is less prominent than changes to implied volatility and time. However, understanding the impact dividends have on option pricing is a good concept to comprehend.
A dividend is a distribution of profits that a company returns to shareholders. Dividends are normally calculated per share and are generally paid quarterly. Approximately 50% of companies with listed options pay dividends.
Prior to the ex-dividend date, stock traders will increase the price of a stock to reflect the imminent payment of a dividend. The dividend will be paid to the shareholder of record on the ex-dividend date. Following the ex-dividend date, a stock price will fall by the amount of the dividend, as shareholders who own the stock after that date are no longer entitled to receive a dividend. The decline in the value of the stock also reflects the reduction in the company’s assets resulting from the declaration of the dividend.
Recall that a call option provides an options buyer the right but not the obligation to purchase a stock at a specific price on or before a certain date. The price at which the underlying stock can be purchased is called the strike price, and the maturity date of the option is referred to as the expiration date. When the price of a stock is above the strike price, it referred to as “in the money” and when the price of the stock is below the strike price, it is referred to as “out of the money.”
The price of an option will fluctuate based on the movements of the price of the underlying stock, because an options is a derivative product of an underlying asset. Since the value of a call option is based on the probability that that stock price will be “in the money,” the expected decline in the price of the stock on the ex-dividend date is incorporated into the value of an option prior to that date.
A put option provides an option buyer the right but not the obligation to sell a stock at a specified price on or before a certain date. The price at which the put option buyer can sell a stock is referred to as the strike price. The date when the option matures is referred to as the expiration date.
When the price of an underlying stock declines, the price of a put option on that stock will generally rise, and when the price of an underlying stock increases, the price of a put option on that stock will generally fall. Prior to the ex-dividend date, the value of a put option reflects the likelihood that the price of the stock will fall by the amount of the dividend, which will no longer be payable after the ex-dividend date.
Most stock options are American-style options, which allow the buyer to exercise the option at any time prior to the expiration date. European-style options only allow the buyer to exercise an option on the expiration date. The distinction is important because the standard option pricing model, known as the Black-Scholes pricing formula, does not value American-style options that have dividend payments.
Although understanding this limitation is important, from a practical standpoint it is not pertinent—most the time, it is disadvantageous to exercise an option early, as you are giving up the remaining time value on an option.
There a several different types of expiration dates associated with options. The most common are monthly option expiration dates. These generally mature on the third Wednesday of each month. There are also weekly expirations, which expire every Friday, as well as quarterly expiration dates.
You want to be cognizant of the time value in your option, prior to the ex-dividend date. Stocks that have a weekly options expiration that immediately follows the ex-dividend date can fluctuate significantly ahead of their expiration date. The Greeks of options with more time value will be less sensitive to changes in the price of a stock due to the ex-dividend date, relative to the Greeks of options that are about to expire.
Since option traders will anticipate a decline in the price of a stock prior to the ex-dividend date, the probability of that decline after the ex-dividend date will be incorporated into the price of a put, making it more expensive, as well as into the price of a call, reducing its value.
When you are purchasing calls or puts on individual stocks, it is important to know on which date the stock is expected to fall, which means you need to know when a stock is going ex-dividend. You can find a complete list of all the stocks that are expected to go ex-dividend in our Ex-Dividend Search tool. You can select the date range of your choice and filter out the results, which you can then download in a spreadsheet.
To know ex-dividend dates for special dividends, you can go to our special dividends tool and find all the stocks that recently announced a special dividend. With special dividends, the stock may not necessarily fall on the ex-dividend date. Learn more about it in our “Everything Investors Need to Know About Special Dividends” section.
Additionally, if you are interested in learning how to use options to create synthetic dividends, check out “How to Earn Dividends from Non-Dividend Paying Stocks” and “Increase Your Yield by Creating a Synthetic Dividend Using Put Options.” There are plenty of companies that do not distribute their profits back to their investors in the form of a dividend, and a synthetic dividend can produce income for investors who are interested in additional cash flow.
Check out our Dividend Stocks and Options page for all the latest regarding options and dividends.
Dividends play a role in determining the price of an option, as the changes to a stock price will fluctuate ahead of a company’s ex-dividend date. Stock prices will rise into a dividend and fall following the ex-dividend date, which is priced into both call and put options. Dividends have less of an impact on the price of an option than changes in other option inputs, including implied volatility and time, but it’s still beneficial to understand the impact dividends have on option pricing.