Last weeks column on Charts and Dividends was one of my most read ever, with 1000+ reads. So, I thought I’d step back a bit and review how the dividend is priced into and option.
Simply put, dividends make puts more expensive and calls cheaper. The puts get more expensive because the downside insurance a put represents is offset by the dividend. The higher the dividend the more I am willing to pay for a put. Calls become cheaper for two reasons: One, a dividend makes a covered write (long stock, short call) more attractive. Two, the stock needs to make up the dividend because the strike price is not adjusted. Say XYZ is trading at 100 and pays a $1 dividend a week before expiration. And we have the 105 call. If XYZ opens at 99 ex-dividend the stock actually opens unchanged because the $1 “loss” in the stock was paid to the shareholders. But! The 105 call is instantly another dollar out of the money.
And let’s not forget, dividends create extra, hidden, expirations. Deep ITM calls for all intents and purposes expire the day before a dividend is paid out (dividends are paid to shareholders, not option owners) and deep ITM puts expire for all intents and purposes the day after the dividend is paid out (there is less reason to hold on to a heavy put plus the stock).
For more on this and the other Five Elements of Option Pricing, I refer you to my book, There’s Always an Option: The Theory and Working Method of Exchange Traded Options.