Dividend stocks are a popular way to generate income, but they also impact several other investment strategies, including option strategies. For example, an investor that’s selling call options to generate an income should be aware of how option prices behave when a company announces and pays a dividend to avoid any surprises.
Let’s take a look at how dividends work, the impact on stock prices, how that translates to options, and what these dynamics mean for investors.
Stock Prices Fall on the Ex-Dividend Date
Many companies pay dividends to their shareholders rather than retaining all of their earnings each year in order to attract income investors.
There are several key dates to keep in mind:
- Declaration Date: The date the company announces the per share amount of its upcoming dividend.
- Ex-Dividend Date: The date that the stock’s price adjusts downward to account for the dividend payment.
- Record Date: The date that shareholders must own a stock in order to be eligible to receive a dividend.
- Payment Date: The date that shareholders actually receive cash in their accounts from the dividend.
Stock prices theoretically fall by the amount of the dividend on the ex-dividend date. For instance, a $0.50 per share dividend would result in a half-point drop in the stock price on the ex-dividend date. In reality, a stock may rise or fall on the ex-dividend date because other factors could influence the price on that day.
While stock prices aren’t impacted by dividends until the ex-dividend date, option prices may start reacting to an anticipated dividend as early as the declaration date. A company that plans to pay an unexpectedly large dividend to shareholders may cause call options to drop in value at the time of the announcement because of its expected impact on the stock price.
Calls Become Cheaper, Puts Become Pricier
The theoretical drop in the stock price has an impact on both call and put options. Call options become cheaper and put options become more expensive due to the anticipated drop in the stock price. Options usually price in these dynamics well in advance of the ex-dividend date, however, so any extra option volatility is rarely noticeable on the actual date that it occurs.
These dynamics impact option traders in a couple of ways:
- Call Options: Call options increase in value when the underlying stock price rises. Since the seller will receive the cash dividend, the option loses value in the days leading up to the ex-dividend date when the price will fall.
- Put Options: Put options increase in value when the underlying stock price falls. Since the underlying stock price falls on the ex-dividend date, the option becomes more expensive as the ex-dividend date approaches.
Most companies pay modest dividends that have little impact on the stock price and options. For example, a $50 per share stock may pay a one percent annual dividend that equates to just $0.50 per share paid out in quarterly installments of $0.125 per share. The $0.125 per share drop on the ex-dividend date is minimal given that a stock may regularly move one percent, or $0.50, due to other factors on a given day.
The impact is more significant for companies that pay high dividend yields. For instance, real estate investment trusts (REITs), master limited partnerships (MLPs), utilities and other high-dividend companies may be required to pay out the majority of their earnings in dividends. These dividend yields may approach 10% and can have a much more significant impact on the stock price and any options.
In addition to the price impact, investors must also consider the tax implications of dividends. A qualified dividend is taxed at the lower, long-term capital gains rate. A dividend will be qualified if you purchased the shares 60 days prior to the ex-date. Short-term traders will experience dividends taxed at their ordinary income tax rates, which can be significantly higher than long-term capital gains tax rates. Traders that buy dividend stocks over the short-term to accrue dividends will face higher tax rates.
Impact on Covered Call Strategies
There are pros and cons to consider when using covered call strategies on dividend stocks—especially those that have high dividend yields.
The biggest pros are that you get to keep the option premium and the dividend amount if you own shares on the record date, which could translate to more income from the overall position. Many dividend stocks are also more stable than growth stocks, which makes them ideal for a retirement portfolio focused on income.
On the other hand, covered call options may have a higher early assignment risk. If a covered call option is in-the-money and the dividend exceeds the remaining time value, there’s a good chance that the owner of the call will exercise their options early. Dividend stocks also tend to be defensive with less volatility, which often translates to lower call option premiums.
Generating Extra Income with Options
Many investors use dividend stocks to generate an income from equities rather than purchasing fixed-income investments with limited upside potential. Unfortunately, dividends alone typically don’t offer high enough yields to offset the income requirements for most retirees. You may need a combination of dividend and fixed-income investments to have enough income to fund your retirement lifestyle.
Covered call options provide an alternative way to generate an income from equities (including dividend-paying equities) without resorting to fixed-income. By selling a call option against a stock position, you can collect premium income in exchange for the obligation to sell at a certain price. The goal is to minimize the odds of your stock position being called away to realize the premium income, any capital gains appreciation, and the dividend payment.
Snider Advisors’ Lattco Platform – Source: Snider Advisors
The Snider Investment Method is a long-term strategy designed to create income from your portfolio and ensure cash flow in retirement. It uses a combination of stock, options and cash, along with specific techniques applied in a specific sequence, to maximize your portfolio’s income potential. We even provide a proprietary stock analysis and automated trading platform called Lattco.
The Bottom Line
Dividends cause a stock price to fall since the company is transferring assets from its coffers to shareholders. In most cases, these small transfers have a minimal impact on the stock price and options, but high yield stocks can experience larger swings.