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Dividends, Options And You: What You Must Know

Friday, January 31, 2014 - 7:00am

There are a number of strategies available to investors that use option contracts to generate attractive levels of income. Two strategies in particular that have become popular with individual investors are selling covered calls and selling puts. These strategies can be implemented through traditional brokerage accounts, as well as through qualified accounts such as IRAs.

Covered Calls: Investors purchase shares of stock and then sell call options against these shares. Selling the call options leaves the investor with an obligation to sell the shares of stock if the price of the stock is above the strike price of the option when the option expires. Income is generated through the proceeds received from selling the call option contracts.

Selling Puts: Investors sell unhedged or "naked" put option contracts on stocks that they expect to trade higher (or at least remain stable). Selling puts obligates the investor to buy shares of stock if the market price falls below the strike price when the option expires. Income is generated through the proceeds received from selling the put option contracts.

One thing many investors miss when setting up these types of trades is the effect of dividends. While the covered call and naked put selling strategies are similar in that they create income from selling option contracts, and that they both work best using stocks that have a bullish bias, dividend payments affect these strategies differently.

How Dividends Affect Covered Call Trades
For covered call trades, dividend payments can make a big difference when it comes to the annualized or per-year returns that we expect to receive from the trade. This is because, as shareholders, we are entitled to receive the dividend payment unless the call option buyer decides to exercise his right to buy the shares from us early.

Basically, dividend payments affect our covered call returns in one of two ways:

1. We may receive the dividend payment alongside the income that we generate from selling call contracts. For a stock that has a 2% dividend yield, a quarterly dividend payment could add 0.5% to our return for the duration of the covered call trade. If we are setting up the trade to be completed in a four- to eight-week timeframe, that 0.5% addition to our income could result in a big boost to our rate of return.

2. The owner of the call option may choose to exercise his right early. While most option contracts are held until expiration (or sold to close the contracts out), the owner of an American-style option has the right to exercise the contract early. This early exercise usually only makes sense when there is a dividend that is being paid.

As sellers of call option contracts, we have no control over whether the call options are exercised early or not. But if the owner of the call contract chooses to exercise his option to buy the stock early, we still benefit, capturing our expected profit on the stock in a shorter time period. When you calculate an annual return based on a shorter time frame, the per-year return actually increases.

So the covered call approach actually benefits from a dividend payment because we either receive the extra income in our account, or we are able to close out our trade early for a higher annualized gain.

How Dividends Affect Naked Put Trades
Dividends affect the put selling strategy in a completely different way. While we are still short an options contract, we do not own the underlying stock. This means that we do not receive the benefit of a dividend payment.

The owner of the put option contracts that we sold still has the right to exercise the put option contract early, but there is essentially no incentive associated with this action. Why would the owner of the put contract choose to sell us the stock at the strike price when the dividend is about to be paid?

Another issue to consider is the statistical drop in price when a stock goes ex-dividend. From a stock investor's perspective, if a company pays a $0.20 dividend each quarter, the stock itself should be worth $0.20 less the day after the dividend is paid.

Of course, this statistical drop in the value of a stock occurs within the context of all other market variables. So an individual stock may still rise or fall depending on the other factors in play. But on average, a stock will drop by the amount of the dividend following the record date when the dividend is allocated to the current shareholder.

The statistical drop in price has the potential to push the stock closer to or below the strike price of our put contract. And if that happens, we could be obligated to buy the stock. Essentially, this strategy loses money as the stock value declines.

So, when selling puts, dividends naturally cause a decline in the stock price, which can be a negative factor for our ultimate returns. An efficient market should result in the premium for put options incorporating this expected drop in the stock price. But as put sellers, we need to be aware of this dividend dynamic and demand a fair price within the context of the expected dividend payment.

A Word About Special Dividends
There are times when a company will pay a special dividend, which is above and beyond the traditional quarterly dividend that is paid. Usually when a special dividend is paid, the strike price for all open option contracts will be adjusted to account for the expected drop in stock price.

So if a stock's board approves a $1 special dividend that is paid during the period when our option contract is open, we can expect that our strike price will drop by a dollar. So a January $50 contract may be converted to a January $49 contract. This still lines up perfectly with the expected value of the stock price.

All option contracts are listed with the Options Price Reporting Authority (OPRA). So for instances where a special dividend or other liquidity event (such as a merger) affects option contracts, OPRA is responsible for determining a fair and equitable treatment of options traders, and communicating adjustments to investors.

This article originally appeared on ProfitableTrading.com:
How Dividends Affect Your Option Income Strategies

P.S. By using a similar options strategy, my colleague Amber Hestla is generating payments of $1,047, $2,435 and $3,410 (and sometimes more) from nearly any stock -- including ones you may already own. This free report explains everything, including names and tickers.

Zachary Scheidt does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.