Dividends and Why Option Contracts are Adjusted?

  by Tyler Curtis

by Tom Doan

When a company declares a special cash dividend, optionsXpress sends emails to investors holding that particular stock saying “underlying option strikes have been reduced accordingly and all open equity and option orders have been cancelled.” These emails cause a fair amount of confusion.  I receive many phone calls asking about the situation and what they should do. In order to know what action to take, we must first understand what this message means.

A special cash dividend is different than a regular dividend. Unlike a regular dividend, a special cash dividend is non-recurring, meaning it is not provided on a regular schedule such as a quarterly basis. When a company pays a dividend, the stock price will fall by the same amount since the amount paid from the dividend no longer belongs to the company but rather the individual shareholders. Option premiums take into account regular dividends since investors know when to anticipate the dividend. However, since special cash dividends are non-recurring and unpredictable, option premiums cannot take them into account. As a result, when the special dividend is declared, the strike prices are adjusted downward by the dividend amount, hence “underlying option strikes have been reduced accordingly.”

Also upon the payment of a special dividend is “all open equity and option orders have been cancelled.” Since the stock price and strike prices have been reduced, all open orders are cancelled. Many clients confuse this with open options, thinking that the open options they sold last month are no longer valid. This is not true because those orders have already been executed and are no longer open, only the strike prices have been adjusted.

In the Snider Method, whenever one of your positions distributes a special cash dividend and you receive the email, what you have to do is: nothing. The dividend does not affect your position, it only adjusts the strike price. Just make sure that if shares are called away, use the adjusted strike price to calculate the profit rather than the original strike price.

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