Risk. It comes in many forms and is always scary—unless you’re playing the board game, that is. But today we’re not playing games. We are here to discuss Dividend Risk and what conditions make this concept relevant to your portfolio.
If your portfolio contains any short call options (you are selling calls), there is a chance that you may be assigned short stock (be forced to sell the buyer of your option the relevant number of shares of the underlying upon the buyer’s exercise of the option) and have to pay the dividend on the underlying symbol.
If you have been assigned and don't know what to do then click here to learn more about your options (no pun intended).
Let’s look at this from the point of view of the trade’s counterparty to gain more perspective on why Dividend Risk even exists:
Imagine that you are the counterparty of the short call option and have purchased a call. If you are the long call holder (the buyer) and it is in the money (ITM) and you learn that there’s an upcoming dividend, chances are that you’ll want to exercise that long call. Why? Because you want to be able to buy the stock at a discount from current market price, collect the upcoming dividend, AND get free protection by purchasing the corresponding put. Additionally, the counterparty could use the purchase of a put as a “dividend capture strategy”, as they could collect the dividend and then sell the stock at the same strike price for a net gain of the dividend amount minus the cost of purchasing the put.
So, generally speaking, out of the money (OTM) calls present little to no dividend risk. A good way to see if a short ITM call in your portfolio presents potential dividend risk is to look at the corresponding put amount. If the extrinsic value of the put is lower than the dividend, chances are that you will be assigned short stock and charged a $5 assignment fee.
Dividend risk also affects risk-defined spreads. If the corresponding put amount is lower than the dividend amount, a risk-defined spread may also lead to you being assigned short stock.
If you happen to already own shares of the underlying symbol, then, upon assignment of the option, the dividend you were entitled to collect will slip out of your grasp and into the pocket of the long call holder.
Before we dive in to an example let's define what an ex-dividend date is since that is typically when investors with short calls may be assigned. The ex-dividend date, or ex-date, is defined as the date investors buying the stock will no longer receive the dividend. Because stock trades take takes days to settle (T+2), the ex-dividend date usually falls one day prior to the record date. Investors that want to receive the dividend therefore need to purchase the stock prior to the ex-dividend date in order to receive the dividend.
Now, let’s look at two examples concerning a real-life symbol - MCD (McDonald’s Corporation):
The first is a naked call position that presents potential dividend risk and the second is another naked call position that presents little to no dividend risk
BOTH screenshots were taken at the SAME time on Wednesday, May 31, 2017 with MCD going ex-dividend on Thursday, June 1, 2017 (next day).
Dividend amount: $0.94/share
Ex-Dividend Date: Thursday, June 1, 2017 - the date when MCD trades without a dividend.
1. Low Dividend Risk
In this example, the value of the dividend does not exceed the put value. Despite the 150 call being in the money, the amount of extrinsic value in the puts makes this a scenario that presents little to no dividend risk to the portfolio-holder.
2. High Dividend Risk
This is a great example of an ITM call that presents high dividend risk. In this case, the $0.94/share dividend that McDonald’s plans to pay out greatly exceeds the put extrinsic value, which is $0.055 (mid-price). Chances are that this portfolio will be assigned 100 short shares of MCD at $135 and owe a dividend of $94 ($0.94 x 100) when the dividend becomes payable on June 19, 2017. Any dividends owed will list as a pending cash entry on your platform.
One preventative measure you can take to reduce the possibility of facing dividend risk through assignment is to roll short ITM calls for a credit to a further date. This compounds extrinsic/time value on the call, and ultimately buys time for the relevant put value to become greater than the dividend value. You can also choose to close the short call by buying it back and accepting the loss, which at least releases you from the obligation of paying the dividend on the dividend payable date (if assigned).
Paying the Dividend if Assigned Short Stock before Ex-Dividend Date
If you were assigned short stock before the ex-dividend date then you will owe the dividend to the counterparty on the dividend payable date. Let’s continue our McDonald's example and take a look at what happens when the dividend is due and paid out after being assigned short stock.
In the example below, this account was assigned 100 short shares at $135 before the ex-dividend date. McDonald’s declared their dividend payable date as June 19th. This means that the dividend will be paid out on that day. Since this account was assigned short stock before the ex-dividend date then this account will be debited the total dividend amount of $94 ($0.94 x 100 shares) on the dividend payable date, as illustrated below.
A final, all-important note: ANY AND ALL short option positions that you hold can be exercised at ANY TIME by their long holder, REGARDLESS of whether or not the exercise benefits them financially. This is generally important to keep in mind when you trade options.
For more on Dividend Risk, visit our friends at tastytrade by clicking here.