How Dividends Affect Your Option Income Strategies

Most of us like the idea of more income in our accounts. Thankfully, more and more investors are realizing that income isn’t limited to dividends alone. There are a number of strategies available to achieve these goals.

Two strategies in particular that have become popular with individual investors are selling covered calls and selling puts. These strategies are relatively simple to learn, and can be implemented through traditional brokerage accounts as well as qualified accounts like IRAs.

We’ll skip some of the basics of those strategies today. Instead, we want to touch on one thing many investors miss when setting up these types of trades. Specifically, we’re referring to the effect dividends can have when these strategies are used.

The covered call and naked put selling strategies are similar in that they create income from selling option contracts. And they both work best using stocks that have a bullish bias. But 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 returns 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 we generate from selling call contracts. For a stock with a 2% dividend yield, a quarterly dividend payment could add 0.5% to our return for the duration of the covered call trade. This may not sound like much at first glance. But if we are setting up the trade with a four-to-eight-week time frame, 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 has the right to exercise the contract early. This early exercise usually only makes sense when there is a dividend 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, we still benefit. It allows us to capture 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. (Again, note that we’re talking about your annualized return, which is important because time is a valuable resource when looking at your trades.)

So the covered call approach actually benefits from a dividend payment. 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.

A possible 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, here’s what you need to remember. 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. 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 to be 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.

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