Dividends are paid because the price of the stock affects the pricing of stock options. How much a stock falls is usually determined by the stock market’s dividend payment ex-dividend date (the first trading day on which an upcoming dividend is not included in the stock price). This movement affects the pricing of options. A call option costs less before the ex-dividend date due to an expected decline in the price of the underlying stock.
At the same time, the price of put options also rose in response to the same expected decline. The math of option pricing is important for investors to understand so they can make informed trading decisions.
KEY TAKEAWAYS
- Stock-listed options are subject to dividend payments because holders of the underlying stock receive dividends, but holders of call and puts options do not receive these inflows.
- When the underlying stock goes ex-dividend, the call option will fall and the put option will appreciate as the stock price reflects the dividend to be paid.
- Holders of American-style call options can choose to exercise these options early before the ex-dividend date to receive dividend payments on the underlying stock.
- The Black-Scholes formula is not suitable for a fair assessment of the value of U.S. dividend-paying stock options.
Share price falls on the ex-dividend date
This record date; is the deadline set by the company to receive dividends. Investors must hold the stock by that date to be eligible for the dividend. However, other rules also apply.
If an investor purchases shares on the record date, that investor will not receive the dividend. This is because a trip takes two days to trade stocks and it is called T+2. Exchanges need time to process the paperwork to settle trades. Therefore, investors must hold the stock until the ex-dividend date.
Therefore, the ex-dividend date is a key date. On the ex-dividend date, other things being equal, the stock price shall fall by the amount of the dividend. This is because the company is forfeiting the money, so the company is now less valuable because the money will soon end up in someone else’s hands. In the real world, everything else is not equal. While in theory, the stock should fall with the amount of the dividend, the stock may rise or fall even more due to other factors (not just the dividend) affecting the price.
Some brokers move; limit orders to accommodate dividend payments. Using the same example, if an investor has a limit order to buy ABC Company stock at $46 and the company is paying a $1 dividend, the broker can move the limit order down to $45. Most brokers have a setting that you can toggle to take advantage of this, or indicate that the investor wants the order to stay as it is.
The effect of dividends on options
Both call and put options are affected by the ex-dividend date. Put options become more expensive because the price falls as the dividend decreases (all else being equal). Call options have become cheaper in anticipation of a drop in stock prices, although for options this may start to price in the weeks leading up to the ex-dividend. To understand why puts increase in value and put fall, let’s look at what happens when an investor buys a call or a put.
Put options increase in value as the stock price falls. A put option stock option is a financial contract whereby the holder has the right to sell 100 shares of stock at a stated strike price until the option expires. If the option is exercised, the writer or seller of the option is obligated to purchase the underlying stock at the exercise price. The seller charges a premium for taking this risk.
Conversely, call options to lose value in the days leading up to the ex-dividend date. A call option on a stock is a contract whereby the buyer has the right to purchase 100 shares of stock at a stated strike price until the expiry date. Since the price of the stock falls on the ex-dividend date, the value of the call option also falls in the time before the ex-dividend date.
Black-Scholes formula
Corporation; the Black-Scholes formula; is a method used to price options. However, the Black-Scholes formula only reflects that European-style options cannot be exercised until the maturity date and if the underlying stock has not paid a dividend. Therefore, this formula is used to calculate; American options are early exercisable dividend-paying stocks.
As a practical matter, stock options are rarely exercised early due to forfeiture of the remaining time value part of the choice. Investors should understand the limitations of the Black-Scholes model in assessing the value of dividend-paying stock options.
The Black-Scholes formula includes the following variables: the price of the underlying stock, the strike price of the option, the time at which the option expires, the price implied volatility, and the risk-free interest rate. Since the formula does not capture the impact of dividend payments, some Experts have ways to circumvent this restriction. A common method is to subtract the present value of future dividends from the stock price.
The formula is:
The implied volatility in the formula is the volatility of the underlying instrument. Some traders believe that an option’s implied volatility is a more useful measure of an option’s value relative to its value. Traders should also consider the implied volatility of dividend-paying stock options. The higher the implied volatility of a stock, the more likely it is that the price will fall. As a result, put options have higher implied volatility ahead of the ex-dividend date due to falling prices.
Most dividends cause little volatility
While substantial dividends may appear in the stock price, most normal dividends have little impact on the stock price or option prices. Take, for example, a $30 stock that pays 1% a year. This equates to $0.30 per share, payable in quarterly installments of $0.075 per share. On the ex-dividend date, all else being equal, the stock price should fall by $0.075. The value of the put option will increase slightly and the value of the call option will decrease slightly. However, in the absence of any news or events, most stocks could easily move 1% or more in a day. Therefore, the stock is likely to rise on the day, although technically, the stock should open lower for the day. Thus, trying to predict micro-movements in stock and options prices based on dividends can mean missing the big picture for stock and options prices in the days and weeks before and after the event.
bottom line
Generally, puts will increase slightly before dividends, and calls will decrease slightly. This is assuming all other things are equal, which is not the case in the real world. Options will price a stock price adjustment (related to dividends) before the stock price adjustment occurs. This means small movements in option prices over time, which are likely to be overwhelmed by other factors. Especially with a small dividend paid, that’s a very small percentage. Large dividends, such as high dividends; let dividends have a more pronounced effect on stock and option prices.
