by Investing Daily, Investing Daily
Article of the Week from Investing Daily
— this post authored by Scott Chan
When you trade options, some relationships seem obvious. That is, if you buy a call option, it’s good for you if the underlying stock price goes up. And if you buy a put option, it’s good for you if the stock price goes down. If you are the option seller, then the opposite is true.
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Moreover, when evaluating which option to buy, you will want to compare the premiums you would have to pay versus how much in or out of the money the option is. You will also want to pick a stock that has high volatility.
However, there are some hidden factors that you may not be aware of.
The Impact of Dividend
One factor is the dividend.
When you are evaluating which option to buy, you need to find out how much dividend the stock is expected to pay out before the option expires because it will impact your trade.
Remember that when a company declares a dividend, on the ex-dividend date, its stock price will be reduced by that amount.
Let’s say you want to buy a September $52 call on stock XYZ, which is trading at $50 now. Before expiration, the underlying stock will pay a $0.50 dividend. If XYZ did not pay any dividend, it would need to move up by $2.01 by expiration to end up in the money. That’s pretty straight forward. But the $0.50 dividend reduces the stock value by $0.50, so in effect XYZ would actually need to increase by $2.51 to end at $52.01 or higher at expiration.
Check the Expected Dividend
This especially comes into play with high-yielding stocks that pay out a large percentage of their stock price as dividend.
So when you see a call option premium that seems curiously low, be sure to double check the expected dividend.
On the other hand, if you are buying a put, the dividend helps you because it lowers the stock price. Along similar lines, if you wrote a call, then the dividend also helps you.
It’s even better for you if you wrote a covered call because not only does the stock price go down, but because you own the stock, you also collect the dividend.
Interest Rates Matter Too
A second factor to be aware of is interest rates. Interest rates have clear impact on the economy and on finance markets, including the option market. All things equal, higher interest rates tend to help call options but hurt put options. To see why, consider the difference between buying a stock outright and buying a call option.
Let’s go back to the XYZ example. Let’s say you want to buy 100 shares of XYZ. At $50 a share you would need to spend $5,000. But if the call option is trading at $1, to get the equivalent exposure to 100 shares, you would only need to spend $100, for one contract (ignoring the commission). So instead of spending $5,000, you could spend $100 and invest the remaining $4,900 in other stocks and options or simply invest it in a “risk-free” asset like a government bond.
Hopefully you see that when interest rates are higher, the second alternative is more attractive because you could earn more in the government bond.
If you decide to exercise the call, you will still need $5,200 to buy the stock. But, if you are exercising the call, it means XYZ is above $52 a share and you have a profit right off the bat. Plus, hopefully the $4,900 that you invested in something else has earned you extra income.
Why High Interest Rate Hurts Puts
When you sell a stock, you receive cash in return. Again, when interest rates are high, you can earn more by investing it in a risk-free asset. But if you decide to buy a put instead of outright selling a stock, you have an extra cash outlay. If you decide to hold an in-the-money put to expiration, you will have to wait until expiration to receive that cash.
This explains why sometimes someone who is long a put would exercise the option before expiration and you will rarely, probably never, see anyone exercise a call before expiration.
Unless interest rates change by a large amount, though, its impact on option prices won’t be as obvious as other factors such as the underlying stock price and time decay. Still, it’s something to keep at the back of your mind in your future option trading endeavor.
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