Two Factors Beginner Options Traders Sometimes Forget

Today we discuss two topics that beginner options traders may not be aware of.

The first is the impact of dividends.

If the underlying stock does not pay any dividend, then the trade is pretty straight forward. For example, if you buy a call on stock XYZ with a strike price of $50, and the stock is trading at $45, then the stock is $5 away from the money.

But let’s say the same stock pays a $0.50 dividend every quarter and there is one ex-dividend date between the time you buy the call and option expiration, then you are actually effectively $5.50 from the money ($5 + $0.50) at the moment of purchase.

On the ex-dividend date, the stock price will adjust downward by $0.50. Thus, the stock price will need to make up that extra $0.50 before it gets to the $50 strike price. This is what I mean by the effective distance being $5.50.

Note that the key is the ex-dividend date, not the actual payment date. The ex-dividend date is when the stock price adjusts downward by the amount of the dividend. If you buy an option after the ex-dividend date but before the payment date, the payment of that dividend will not affect the stock price since the price has already been adjusted.

Dividend Baked Into Premium

If you are buying a put instead, a dividend helps you in the sense that it reduces the distance to being in the money. So if you bought a $40 put on XYZ (again, trading at $45), the put is effectively $4.50 from the money at the moment of purchase since in the future the dividend will lower the stock price by $0.50.

If you were the option seller instead of the buyer, the dividend will help you as the call seller and hurt you as the put seller. (Opposite of when you are long the options.)

The market isn’t stupid. Therefore, the expected value of the future dividend(s) is implicitly baked into the option premium. Thus, all else equal, the expected dividend adjustment increases the premium for a put and decreases it for a call. You must take this into account when considering which option to buy.

If you ever notice a premium discrepancy between a put and a call on the same stock, the dividend is likely the reason. Don’t assume that the call is “cheaper” than the put just because the premium is lower.

When a Stock Splits

Next, we look at a rarer occurrence, what happens to options when the underlying stock undergoes a stock split or a reverse splits.

First, let’s review what happens when a stock splits. For example, if you had 100 shares of XYZ worth $50 each, after a 2-for-1 split, you will have 200 shares priced $25 each. The total value of your XYZ position remains unchanged at $5,000. In a 1-for-2 reverse split, you will end up with 50 shares worth $100 each. Again, the total value stays at $5,000.

The good news for option traders is that in the event of a stock split or reverse split, their option positions will be automatically adjusted such that their exposure to the underlying stock remains the same.

Sometimes, when a high-priced stock splits, the lower (note: not cheaper) price could attract some additional buying interest. But other than that, it doesn’t affect the valuation of the option much.

If you were long one contract of a call with a strike price of $50, after the automatic adjustment for a 2-for-1 split you will end up with two contracts, each with a strike price of $25. Prior to the split, the call option gave you the right to purchase 100 shares of XYZ at $50 per share, for a total of $5,000. After the split, the options give you the right to purchase 200 shares of XYZ at $25 per share, also for a total of $5,000.

Normally, one option contract covers 100 shares. In the case of a 1-for-2 reverse split, however, each option contract will cover just 50 shares, and the strike price will double. Continuing with the above example, this means the strike price will double to $100. Thus, the total value of XYZ that the option gives you the right to buy is still $5,000.

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