More than 80 percent of large-cap companies in the S&P 500 index pay dividends, along with about 70 percent of mid-cap companies and just over half of small-cap companies. Many retirees rely on dividend income to fund their retirement without selling stock. Since covered call strategies are a great way to enhance the income from a portfolio, investors must account for the impact of dividends when establishing covered call positions.
In this article, we will look at how dividends impact options and some important considerations for those using covered call strategies.
Dividends and Options
Dividend payments are made to shareholders that own a stock prior to the ex-dividend date, which is the record date plus the two days that it takes for a stock transaction to settle. On the ex-dividend date, the stock price should drop by the amount of the dividend since that money is coming directly from the company’s cash assets. The actual drop may not be equal to that amount because there are other factors that constantly influence the stock price.
There are many different factors that influence the value of a stock option, including the current stock price, intrinsic value, time value, volatility, interest rates—and cash dividend payments. Options with an expiration date inclusive of the underlying stocks’ ex-dividend date have a valuation that takes into account these projected cash dividends.
The impact on option pricing depends on the type of option:
- Call options gain value when the underlying stock price rises. These options are usually priced with the assumption that they will be exercised on the expiration date. Since the call option seller will receive the cash dividend in that case, the option loses value in the days leading up to the ex-dividend date, when the underlying price will fall.
- Put options gain value when the underlying stock price falls. These options are also priced with the assumption that they will be exercised on the expiration date. Since the underlying stock price falls on the ex-dividend date, put options become more expensive as the ex-dividend date approaches.
These dynamics are usually already priced into the option market, but investors should be aware of why there’s a premium or discount priced into the options. Without this awareness, an investor might assume that there is a valuation gap and make a trade on false assumptions.
In most cases, the dividend amount isn’t enough to meaningfully impact the underlying stock price or option pricing. A $50.00 per share stock that pays a one percent dividend each year only pays out $0.50 per share or about $0.12 per quarter. High-yield dividend stocks represent instances where dividends can be much more impactful on stock and option prices.
Impact on Covered Calls
Covered call strategies involve selling call options against an underlying stock position. For example, an investor might own 100 shares of Acme Co. and sell one call option contract against that position. The investor receives the option premium, any dividends paid on the underlying stock, and any appreciation leading up to the strike price. These three income sources can lead to attractive returns for covered call strategies.
Call options with an expiration date that’s inclusive of the ex-dividend date of a dividend paying stock are often priced lower to account for the dividend. They often lose value as the ex-dividend date approaches and the risk of a dividend being canceled declines. As a result, the investor using the covered call strategy receives less of a premium from the option but receives the cash dividend from holding the underlying stock that should offset that amount.
There are several pros to writing covered calls on dividend stocks:
- The investor gets to keep the option premium and the dividend amount if they own the shares on the record date, which could translate to more income from the overall position.
- Many dividend paying stocks are ideal for retirement investors given their stability, predictability, and dividend income.
There are also several cons to consider:
- Dividend paying stocks tend to be defensive in nature, which means less volatility and lower call option premiums.
- Call options with expiration dates inclusive of ex-dividend dates tend to have low option premiums due to the expected decline in stock price.
- There may be a greater risk of the stock being called away when using the strategy on more volatile high-yield dividend stocks.
One of the most common reasons for an early exercise of your call option may be a dividend payment. The option buyer may exercise the call early so that they own the stock on the record date to receive the dividend payment. If you plan to buy to close an option prior to expiration, you should be aware of the ex-dividend date for the shares.
Investors should be aware of the impact that dividends can have on covered call strategies—especially with volatile high-yield dividend paying stocks. The best way to do this is to have a well-defined plan in place to guide both the selection of underlying stocks and the selection of call options to minimize the risk of the option being called away and maximize total income. If you are a fan of the income generation of a dividend stock portfolio, adding covered calls to the strategy is a great way to create even more income.
The Snider Method is designed to help investors maximize income from covered call option strategies using a well-defined strategy that takes dividends and other factors into account, including portfolio construction, capital allocation, and trade management. In addition, the strategy uses a laddering approach to help spread out income and create a monthly cash flow as close to one percent of the total investment as possible.
The Bottom Line
Dividends can have a significant impact on covered call strategies since it impacts the price of the underlying stock. For many large-cap companies, the impact of dividends is minimal and already priced into the options, but there may be less income potential from these companies. Investors should be most careful with high-yield dividend stocks that may be more volatile, although the potential income from these companies can be higher.
In the end, many investors using covered call strategies don’t avoid dividend paying stocks but it’s important to realize how they can impact your portfolio.