We all know why everyone loves dividends.
After all, you’re “getting paid” for doing nothing more than buying shares of a company. You’re not actually hauling products to their stores and stocking their shelves. And it’s not like you’re making the decisions on how to run to run that company, either.
So that’s a pretty sweet deal for investors.
But not for options traders.
In fact, dividends could be your worst nightmare when you’ve got options in your portfolio…
Unless you know this little trick…
The Trick to Trading Options on Dividend Stocks
Before we get into the best way of trading options around dividends, I want to make sure you know the following key terms – they’re absolutely crucial to your options trades:
You’ll want to keep these dates close to you when you’ve got options on dividend stocks in your portfolio – particularly in-the-money (ITM) options. A call is ITM when the strike price is lower than the current stock price. A put is ITM when the strike price is higher than the current stock price.
There’s heightened risk in being assigned if you sold an ITM option or the option you sold goes ITM and the extrinsic value is less than the dividend amount. That’s why it’s extremely important to know the amount of the dividend (which you’ll find out on the declaration date) and what the time value (also called “extrinsic value”) of your option is. The time (or extrinsic) value is simply the option’s price minus the amount by which it’s ITM.
Here’s the trick to calculating whether or not you’re at risk…
To show you how you can determine whether or not your option trade’s at risk of being assigned, let’s look at an example of selling a call option on a dividend stock. In this scenario, the stock is trading at $27 and the call’s strike price is $30. The premium (or price) of the sold option is $3.20, which means the extrinsic value is $0.20. The dividend amount is $.30.
This means that someone (or the market) can sell the option for $3.20 and take in $3.00 intrinsic (real) value and $0.20 of extrinsic (time) value (looking for profit of $3.20 less what they paid for the option)…
They can exercise the right to buy the stock at $30 (thereby giving up the $0.20 extrinsic value) and gladly take in the $0.30 dividend – making an extra $0.10 by doing so (that’s $0.30 made on the dividend versus the $0.20 on the time value portion just trading the option).
In this example, the risk of assignment is clear and present because the seller (or the market) has the right to come and buy the stock at that strike price ($30). That means the buyer would need to go and buy the stock at the current market price in order to give it to the seller at the strike price. And that’s exactly why your risk of assignment is greatest on sold options that are or become ITM.
So here are two thing you can consider if an option on a dividend stock is – or will soon become – ITM:
There’s one more thing you’ll need to know…
Full story at Power Profit Trades