Your golf partner says she has a newfound interest in event driven trading and wonders “how do special dividends affect options?” You tee off and finish your swing with a picture-perfect follow-through. As the ball hooks to the right and disappears in the rough never to be seen again, you turn to her and say …
How Do Special Dividends Affect Options?
Special dividends affect options in three areas: the strike price, the option premium, and impacts early exercise decisions. To understand how do special dividends affect options, we will need to briefly review the terminology involved.
Special dividends are periodic, non-recurring cash distributions to a company’s shareholders. These dividends are in addition to the firm’s regularly scheduled distributions.
Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell the underlying asset at a predetermined price on or before a specific date. They are derivatives because they derive their value from the underlying asset, which can be stocks, bonds, currencies, indices, interest rates, or other assets. The two types of options are call and put options.
Call options give the holder the right to buy and put options give the holder the right to sell the underlying asset at a specific price, known as the strike price, within a specific period.
The strike price is the price the underlying asset can be bought or sold when the option is exercised. The strike price is also called the exercise price.
An option premium is the price the buyer of the option pays to the option seller for the conveyed rights of the option.
The option expiration date is the date the option expires. If the option is not exercised, it becomes worthless. Exercising an option is the process in which the option holder chooses to buy (if it’s a call option) or sell (if the option is a put option) the underlying asset at the predetermined strike price on or before the expiration date.
We are now armed and ready to see how do special dividends affect options, which is paramount for option traders to manage their positions effectively.
Special Dividends Impact on Options
Strike Price Adjustment – When a company declares a special dividend the strike price of the firm’s call and put options is adjusted to reflect the amount of the special dividend. The adjustment ensures that option investors do not gain an unfair advantage or suffer unwarranted consequences due to the special distribution.
If a call option has a strike price of $60 and the special dividend is $4.00, the adjusted strike price is $56. The adjustment is applied on the ex-dividend date. The ex-dividend date determines who is eligible to receive dividend payments. You must be a shareholder before the ex-dividend date to receive dividend payments.
Option Premium Impact – When a special dividend is declared, the underlying stock price will decline in the amount of the dividend on the ex-dividend date. The call option premium drops by the amount of the special dividend.
The put option premium will increase by the amount of the dividend as the underlying stock price falls by the amount of the special dividend on the ex-dividend date.
Early Exercise Decision – Options come in two favors: American-style and European style. Holders of American-style options can exercise the option on or before the expiration date, whereas European-style option holders can exercise the option only on the expiration date and not before.
American-style call option holders may elect to exercise the option early to capture the dividend. This practice is seldom utilized with European-style options due to the lack of exercise flexibility.
Put option holders do not have an incentive to capture dividend payments because dividends are paid to shareholders and exercising a put option does not make the put holder a shareholder. The put option holder is a seller of the underlying asset.
Determining how do special dividends affect options is to understand that the strike price adjustment reflects the dividend distribution, which affects call and put option premiums.
