The Effects of Dividends on Option Prices
The rate of decay of an option premium due to time decay (theta)
increases the closer an option gets to expiration. The trader of
calendar spread tries to capitialize on this by selling the short
term option, which has a higher short term time premium, and buying
the long term option at the same strike to hedge against movement in
the stock.
What if the underlying stock pays a large dividend after the expiration of the short term option and before the expiration of the long term option? The long term option is discounted by the premium, the short term option is not.
The result is the long term option can be purchased at a discount making the hedge against loss for the short term option cheaper.
Consider the following calendar spread as an example:
It is early July and FRO is trading at $40 a share. FRO pays
a $3.00 dividend and goes ex-dividend on September 20. The October $40
call, which normally would trade at a high premium due to the
underlying stock's volatility, is trading at a discounted price of
$2.20. The call is discounted because the stock will drop $3.00 when
the dividend is paid in September. The August 40 call, which is not
effected by the dividend, is trading at $2.00.
Short selling the August 40 call and buying the October 40 call will
cost a mere .20 cents. At the August expiration, the time premium on
the August call will be close to zero, and the time premium on the
October call will be reduced, but still represent two months
premium. Any intrinsic value in the August call will be offset by the
intrinsic value in the October call.
Take the simple scenario where FRO is trading at $40 near
expiration. The August call is worthless, and the October call is
worth approximately $1.10. The return on this trade is $1.10, but the risk
is relatively low (20 cents).
There can be an advantage to trading calendar spreads on stocks with
large dividends, particularly on stocks whose dividend varies and is
unpredictable, because the long leg is discounted by the dividend and
the short leg is not.
The Dividend Report shows stocks that have both high volatility and dividends.
The following sample of the Dividend
1 |
GBX |
GREENBRIER COMPANIES INC |
26.80 |
2007-01-22 |
0.32 |
1.19 |
0.44 |
2 |
WST |
WEST PHARMACEUTICAL SERVICES |
47.65 |
2007-01-22 |
0.52 |
1.09 |
0.32 |
3 |
FFH |
FAIRFAX FINANCIAL HOLDINGS |
176.80 |
2007-01-23 |
2.75 |
1.56 |
0.39 |
4 |
WSM |
WILLIAMS SONOMA INC |
34.52 |
2007-01-24 |
0.40 |
1.16 |
0.29 |
5 |
PNR |
PENTAIR INC |
30.29 |
2007-01-24 |
0.60 |
1.98 |
0.22 |
6 |
DHI |
HORTON INC |
27.53 |
2007-01-24 |
0.60 |
2.18 |
0.34 |
7 |
CAG |
CONAGRA FOODS INC |
26.66 |
2007-01-25 |
0.72 |
2.70 |
0.34 |
8 |
LLTC |
LINEAR TECH CP |
30.37 |
2007-01-25 |
0.60 |
1.98 |
0.27 |
9 |
CNB |
COLONIAL BANCGROUP INC |
24.48 |
2007-01-25 |
0.68 |
2.78 |
0.21 |
10 |
EGLE |
EAGLE BULK SHIPPING INC |
17.43 |
2007-01-26 |
2.04 |
11.70 |
0.38 |
11 |
UNM |
UNUMPROVIDENT CP |
20.22 |
2007-01-26 |
0.30 |
1.48 |
0.26 |
12 |
APOG |
APOGEE ENTERPRISES INC |
19.11 |
2007-01-27 |
0.27 |
1.41 |
0.35 |
13 |
FNM |
FANNIE MAE |
57.00 |
2007-01-27 |
1.04 |
1.82 |
0.21 |
14 |
COP |
CONOCOPHILLIPS |
63.95 |
2007-01-27 |
1.44 |
2.25 |
0.29 |
15 |
CRR |
CARBO CERAMICS INC |
35.08 |
2007-01-29 |
0.48 |
1.37 |
0.39 |
16 |
NCX |
NOVA CHEMICALS CP |
30.17 |
2007-01-29 |
0.36 |
1.19 |
0.35 |
17 |
AOS |
A O SMITH CP |
36.00 |
2007-01-29 |
0.68 |
1.89 |
0.38 |
18 |
CEI |
CRESCENT REAL ESTATE EQUITIES |
19.92 |
2007-01-29 |
1.50 |
7.53 |
0.21 |
19 |
PVX |
PROVIDENT ENERGY TRUST |
10.37 |
2007-01-29 |
1.22 |
11.76 |
0.21 |
20 |
CNE |
CANETIC RESOURCES TRUST |
12.87 |
2007-01-29 |
1.94 |
15.07 |
0.27 |
| |
Disclaimer: Dividend dates and yields are estimated from prior dividend activity. Reported dividends may not have been declared by the underlying company, there is no guarantee that the reported dividend will actually be paid on any date, in any amount, or at all. This report is for informational purposes only and should not be used as the basis for any investment decision.