by Investing Daily, Investing Daily
— this post authored by Scott Chan
When you buy a stock, you can make money in two ways.
- The first is to sell the stock at a higher price than you paid for it.
- The second is collecting the dividend the company pays to its shareholders.
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Since a stock price can move up or down, the first way is not guaranteed to generate a profit. And of course, if your investment doesn’t pay a dividend, the second way is irrelevant.
However, in general, a dividend-paying company (especially U.S. companies) will continue to pay dividends to shareholders in a regular quarterly pattern. Therefore, the dividend is typically a more predictable source of income.
The Appeal of Income
This is why conservative investors like to invest in companies that have a consistent history of paying and increasing dividends. They like the feeling of being able to count on receiving the income every three months. A high-yielding portfolio can generate a nice sum over time.
Investors interested in squeezing more income out of their portfolios aren’t limited to stock dividends. Selling options is a popular supplementary strategy to generate additional income.
But if you sell an option in a stock, you should understand how that stock’s dividend will affect the underlying stock price.
A Dividend Overview
For a company to pay a dividend, its board of directors has to review the company’s financial conditions and vote to approve the payout amount. The board also determines the payment date and the record payment date.
The payment date is self-explanatory. It’s the day the company will send out payments.
The record date is a little bit trickier.
Only shareholders of record on the record date are eligible for the dividend. Since a stock trade takes two business days to settle, to receive the upcoming dividend you must buy that stock at least two business days before the record date.
Why the Ex-Date Matters
You have likely heard of the term “ex-date” (or “ex-dividend date”). The ex-date is always one business day before the record date.
If you buy the stock on or after the ex-date, you will not get the next dividend. Recall that it takes two days for a stock trade to settle, so the stock buyer who buys on the ex-date becomes the owner of record one day after the record date.
Conversely, this means that if you sell the stock on or after its ex-date, you will be entitled to the next dividend even though you no longer hold the stock!
Because buyers on a stock’s ex-date will not be eligible for the next dividend, the stock price will adjust downward by the dividend amount.
Many variables can affect a stock price, so in reality the stock price on the ex-date probably won’t change in the exact same amount as the dividend.
How This Relates to Options
As mentioned earlier, on the ex-date, all things equal, the stock price will adjust downward for the future payment of the next dividend.
Thus, if you are selling a call option on a stock that will have one or more ex-dates between now and the expiration date, you can expect the dividend(s) to help you. On the other hand, if you are selling a put option, in the same scenario you can expect the dividend(s) to hurt you.
The market knows this and adjusts the option premium accordingly.
A Real Life Example
Consider the Verizon (NYSE: VZ) October 18 $60 call and put options. Even though both options are roughly at the money, as the small table shows, the put premium is much higher.
This is because Verizon has an upcoming $0.615 dividend, and its ex-date is October 9 (the day this article is published).
For no other reasons other than the dividend cutoff, VZ will fall by $0.615 on October 9. Therefore, call option buyers and put option sellers need to be compensated in the form of a lower call premium and higher put premium.
Don’t Be Fooled
To adjust for the dividend, you should add $0.615 to the call premium and subtract $0.615 from the put premium. Otherwise you could be fooled into thinking the put premium is higher than it really is.
The bottom line is that if you are considering selling options to boost income, don’t forget to check out the stock’s dividend schedule to get a better picture of whether you are getting a good deal or not.
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