While options investors will not receive dividends if they do not own the stock, there are times when trades are exposed to option dividend risk for short calls in the money.
Let’s see why it is a risk and what to do in this situation.
For example, suppose an option investor has placed a diagonal call distribution in Abbvie (ABBV).
Date: January 11, 2020
Price: $ 109.02
Buy an ABBV Feb 19 $ 100 call @ $ 9.25
Sell an ABBV Jan 29th $ 105 Call @ $ 4.40
Direct debit: $ 4.85
(We’ll see later why this diagonal trade was constructed incorrectly, which caused the early assignment problem.)
Nasdaq.com shows that ABBV will pay a dividend of $ 1.30 on February 16 (payment date) to all shareholders registered on January 15 (record date).
To be “on record”, the investor must buy the stock before the ex-dividend date on January 14th (as it takes some time for the purchase to show on the books).
That means the investor has to buy the stock on January 13thth no later than.
Note that the diagonal spread has sold a call option giving the buyer of that call the right to purchase 100 ABBV shares at any time through January 29 at a price of $ 105.
This is known as Exercise right.
An hour before the market closed on January 13, ABBV was trading at $ 112.88.
The call option at Strike $ 105 is in the money.
More specifically, it’s in the money around $ 7.88.
At the same time, the call option is valued at USD 7.90.
This means that $ 7.88 of the price of this option is the intrinsic value.
The remaining $ 0.02 are extrinsic values.
Whenever the holder of an option exercises this option early (before expiration), the holder will give up the external value of the option when converting the option into shares.
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In this case, $ 0.02 per share isn’t much to give up, especially if converting to stock means he or she will receive the dividend of $ 1.30 per share.
Hence the call option is in high risk of exercising.
It makes financial sense to do this.
While all American-style options may be exercisable early, an in-the-money call option with an external value less than the dividend payout prior to the ex-dividend date has an even higher chance of being exercised early.
Assume that the diagonal call option is exercised early. What happens to the option investor who placed the diagonal and sold the call?
The option investor would have sold 100 ABBV shares to the other party at a price of US $ 105.
If the option investor had the shares (as in a covered call), the shares are called.
If the option investor does not own the stocks (as possibly in the case of the diagonal spread), negative 100 ABBV stocks will appear on the account.
The investor has just cut 100 shares in ABBV and needs to buy to cover those 100 shares at some point in the future.
If the investor is short of 100 shares of ABBV on the day of transition from January 13th to January 14th, the investor will be required to pay that dividend of $ 1.30 per share.
The broker will just take it from the account.
This can happen if the investor does not know the short stock in time or is unable to cover it.
If you take a close look at the diagonal trade above, you will find that the short call option was already in the money when the trade began. Diagonals can be constructed with calls or with puts.
In this case, the investor should have constructed the diagonal with all puts instead of calls. Like this:
Date: January 11, 2020
Price: $ 109.02
Buy an ABBV February 19 $ 100 Put @ $ 1.32
Sell an ABBV Jan 29th $ 105 Put @ $ 1.32
Recognition: $ 0.00
Neither leg of the option is in the money at the start of trading.
The payoff chart would have been similar and by buying with puts instead of calls we eliminated option dividend risk.
By using puts when the option strikes are below the current price, and by using calls when the option strikes are above the current price, we reduce the risk of allocation (but do not eliminate it).
A short call with no money can still be at risk of being exercised if the external value is below the dividend.
Even if the extrinsic value is not below the dividend, there may still be instances when the other party may wish to exercise early.
Calls are more likely to be allocated early than puts because the owners of the call may want to train early to get into a stock that pays a dividend.
Ways to reduce the risk of referral are:
- Structure trades that keep your short options out of the money for as long as possible
- Try to avoid running out of money for short options
- With a quick phone call, watch out for possible upcoming ex-dividend dates.
And act safely.
Disclaimer: The information above applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.