Option pricing can be difficult to understand under ordinary circumstances. But the addition of dividends throws an additional wrench into the calculation process; a wrench that is likely to surprise some option holders when Apple (NASDAQ:AAPL) goes ex-dividend on August 9th.
The reason that dividends are a nuisance for option traders is that the ex-dividend date often comes with a decline in the underlying share price. As of the close of trading on August 8th, every owner of any of the nearly 1 billion shares of Apple stock will be entitled to the future payment of the $2.65 per share dividend. Anyone who purchases shares beginning at the open of trading on August 9th, the ex-dividend date, will not be entitled to the dividend. All other market forces being equal, shares of Apple will thus be worth $2.65 less at the open on August 9th as they were at the close on August 8th.
Traders of options are aware of the effect of the ex-dividend-induced decline in share price, and as a result option premiums are affected as well. Call premiums tend to decrease prior to an ex-dividend date, while put premiums tend to be higher than what otherwise might be expected.
The increase in Put premiums is fairly simple to understand. Because new shareholders on August 9th will not receive the $2.65 dividend of current shareholders from August 8th, the stock is essentially worth $2.65 less than it was a day earlier. Because of the anticipated drop in share price, Put sellers demand higher premiums and Put buyers are willing to pay them.
The effect of dividends on Put premiums has a high correlation to the strike price of the option:
- Puts that are out-of-the-money have a high probability of expiring worthless, regardless of the passing of an ex-dividend date, and therefore the "surcharge" on the premiums will be minor.
- Puts that are at-the-money will have a "surcharge" equal to about half of the dividend amount.
- Puts that are deep in-the-money are almost certain to expire deeper in-the-money with the passing of the ex-dividend date, and therefore the "surcharge" on the premiums will approach the value of the dividend.
With the underlying share price near $620:
A $650 Aug. Put might have a "surcharge" near $2.65, to account for the anticipated $2.65 ex-dividend price decline.
A $620 Aug. Put might have a "surcharge" of $1.30 due to the increased likelihood that it will expire in-the-money after the ex-dividend date.
A $570 Aug. Put might have a "surcharge" of only a few pennies, because the anticipated decline in share price on the ex-dividend date is unlikely to prevent it from expiring worthless.
The effect of dividends on Call premiums is not as simple as the effect on Puts. Because of the anticipated drop in share price on the ex-dividend date, Call buyers demand lower premiums and Call sellers are forced to accept them. However, the value of exercising a Call option early, prior to the ex-dividend date, in order to qualify for the dividend payment tends to offset the discount on premiums on in-the-money Call options.
- Calls that are out-of-the-money are likely to expire worthless, and the passing of the ex-dividend only increases that probability, therefore the premiums are mostly unaffected but may be reduced slightly.
- Calls that are at-the-money have a higher probability of being affected by anticipated drop in share price on the ex-dividend date; therefore the "discount" in premiums is higher.
- Calls that are in-the-money do not necessarily have a higher "discount" than those which are at-the-money. While in-the-money Call options do have a "discount" due to the perception of an ex-dividend induced decline in share price, they also have a "surcharge" due to the ability of buyers to exercise them and qualify for a dividend. Since AAPL options are American-style, they can be exercised at any time prior to expiration. Absent a dividend, early exercise rarely makes sense because doing so results in a loss of all remaining time value which would not be lost by simply selling the option. But, because the holder of a Call option does not qualify for the dividend unless the option is exercised prior to the ex-dividend date, the loss of remaining time value through early-exercise in order to qualify for the dividend payment can be more valuable than selling the option with its time value intact and not qualifying for the dividend. The end result is that deep in-the-money Calls often trade at par with the underlying shares prior to an ex-dividend date.
With the underlying share price near $620:
A $650 Aug. Call might have a "discount" of only a few pennies, because it was probably going to expire worthless even without the passing of the ex-dividend date.
A $620 Aug. Call might have a "discount" of $1.30 or so, to account for the decreased likelihood it will expire in-the-money after the ex-dividend date. This discount would probably not be offset by a "surcharge" greater than a few pennies, because the remaining time value of the option makes early exercise too expensive; selling the option is usually more profitable.
A $570 Aug. Call might have a "discount" near $2.65 to account for the anticipated $2.65 ex-dividend decline in share price, but it would likely be offset by a "surcharge" of $2 or more because the lack of significant time value remaining in the option makes early exercise a valuable means of qualifying for the dividend.
Of course, all of these discounts and surcharges disappear when the market opens on August 9th. There will no doubt be some option traders, unfamiliar with ex-dividend dates, left scratching their heads. It is quite possible for the underlying share price to fall by $2.65 on the ex-dividend date without any corresponding increase in the premium of a Put option at the $650 strike. It is also possible for the same drop in share price to be accompanied by an increase in the premium of a Call option at the $570 strike. Such seemingly contradictory effects on option premiums are to be expected on the ex-dividend date.
The preceding is a post by Christopher Ebert, co-author of the book "Show Me Your Options!". He often receives questions about options and attempts to personally answer each one. Questions may be entered in the comment box below, or sent to email@example.com. Your email address will not be published.
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