Which position is subject to dividend risk?
Dividend risk affects short calls
If your portfolio contains any short call options, then there is a chance that you may be forced to sell 100 shares (per contract) of the underlying and pay the dividend on the payable date. As a result, your account will be short the stock and owe the upcoming dividend. However, if you are long the stock and your shares are called away then you lose the dividend payment.
If you have been assigned and don't know what to do then click here to learn more about your options (no pun intended).
How can dividend risk affect my portfolio?
Let's see why dividend risk exists
Imagine instead of being short the call you owned the call. When there is an upcoming dividend it can potentially yield a risk-free profit to the owner of the long call if the corresponding put costs less than the upcoming dividend amount.
For example, let's say you are the owner of a 100-strike call and the upcoming dividend is $1/share ($100 total) and the corresponding 100-strike put cost $0.25 ($25 total). Well, the owner of the call can turn this into a risk-free profit by exercising the call before the ex-dividend date and simultaneously purchase the corresponding put, resulting in a $75 profit ($100 dividend payment - $25 cost of put).
ITM vs. OTM Calls
Dividend risk can affect all options strategies that have a short call component. That includes long or short call spreads, iron condors, calendars, diagonals, strangles, straddles, etc. especially when the corresponding put of the short call is lower than the dividend amount. That said, ITM calls generally have a higher potential of dividend risk than OTM calls.
What is an ex-dividend date?
Understanding this date may help you prevent an upcoming assignment
Before we dive into 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 two days to settle (T+2), the ex-dividend date usually falls one business day before the record date. Investors that wish to receive the dividend, therefore, need to purchase the stock before the ex-dividend date to be recorded as an owner of the shares to receive the dividend.
Example of Ex-Dividend Date
Stock Record date: Wednesday
Due to stock settlement times (T+2), the last day to purchase the stock or exercise a long call(s) to be entitled to the dividend is Monday or the trading day before the ex-date.
|Last day to buy shares or exercise long call(s) to be eligible for the dividend.||Ex-date|
When stock trades without the dividend.
Owners of the shares are entitled to dividend
|Buy Shares||1st day of Settlement||2nd of Settlement|
Dividend Risk Example
Low Dividend Risk vs. High Dividend Risk
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.
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.
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.
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