Effect of Dividends

What is Dividend?

When a company makes profit and wants to reward the shareholders for investing in the company, the board of the directors issue payoff per share which is known as Dividend.

Dividend reduces the cash holdings and hence, the total book value of the company. So, An increase in dividends lowers the forward price of the stock and vice versa. The stock price is expected to drop by the amount of the dividend on the ex-dividend date. (Typically, the investor who buys the stocks on its ex-dividend date or later will not be eligible to receive dividends!)

Effects of Dividends on Stock Options

Many options traders are ignorant about the effects of dividends on stock options. In India, We trade European options. Black-Scholes model was designed to evaluate European options only which don’t permit early exercise. So it does not even take dividends into consideration in the calculation of theoretical options premium.

Dividends, however, have the opposite effect on stock options as changes in interest rates.

Effects of Dividends on Put Options

If a stock is expected to drop by a certain amount, that drop would already have been priced into the extrinsic value of its put options way beforehand.

Let’s have a slightly different analogy. If you are short a dividend paying stock, you would be expected to pay back the dividends declared while no such payback is needed if you own its put options instead. This makes owning put options on dividend paying stocks more desirable than shorting the stocks itself.

So, if seen in the reverse way, sellers of put options in dividend paying stocks are assumed to give the dividends.

So, Dividend means higher put premiums.

Effects of Dividends on Call Options

ll the previously discussed analogies can be justified for Call options too.

In short, sellers of call options on dividend paying stocks are assumed to receive the dividends and hence the call options can get discounted by as much as the dividend amount.

So, Dividend means lower call premiums.

Effect of Dividends on Calendar Spreads

• If all the options have the same expiry cycle, the effect of dividend eases out as it will have almost equal effect on all the options. So, the change in the value of the spread will be negligible.
• But, We are having a calendar spread here! If atleast one dividend payment is expected between the expiration cycles, the dividend will cause a call calendar spread to narrow (like premiums of call options get contracted) and will cause a put calendar spread to expand.

A notable fact is – If the stocks pay no dividend, then the value of a call calendar spread should always have more value than 0. It will be at least the worth of cost of carry.

Although there are no greeks associated with dividend risk, we can safely say a call option/spread/calendar spread has negative dividend risk and vice versa.

^[1]The risk in government bonds doesn’t come from default since the government can print as much as it likes. But the risk comes from the devaluation of the currency due to inflation (caused by said money printing). Refer to Venezuela, Zimbabwe