So You Want to Trade Options: Two Ways to Play Dividends

              

So, you want to trade options, do you? Luckily, you've come to the right place -- here at Schaeffer's, we're all options, all the time. Of course, trading options is easier said than done, particularly if you're brand-new to the exciting world of derivatives. Each week, So You Want to Trade Options is here for you with guidance, definitions, insider tips, and behind-the-scenes information.

As you may or may not be aware, dividends are one of the many factors that influence an option's price. Because dividends don't have as big an impact as other variables, such as time decay and implied volatility, they're generally not a topic that I dedicate a lot of time and analysis to. However, every option trader worth his or her respective salt should know that dividends create trading opportunities (even if only so that he or she can break out this tidbit at particularly boring cocktail parties). So, in today's column, we're going to take a look at two common ways to trade around dividends.

Dividend arbitrage

First up is dividend arbitrage, which uses a combination of stock and in-the-money puts to capitalize on dividend-related price changes. In the crudest possible terms, I would define arbitrage as an attempt to make money by exploiting minor price discrepancies in the market. In other words, this is not a strategy with major profit potential. Instead, it's more like a micro version of the embezzling scheme from the classic film Office Space, minus the white collar-crime aspect.

Before we dissect the trade, let's discuss the basics. When a company goes ex-dividend, the stock will usually drop by the amount of the expected payout. For example, if Generic Company (XYZ) is shelling out $1 to shareholders as of Oct. 5, the stock will generally decline by $1 on that date. So, if you think you can make easy money by simply buying shares on the ex-div date, don't be fooled -- the decline in the stock will offset any gains from the dividend.

Dividend payments are known events, so any scheduled dividends will be accounted for in the pricing of options. Since a dividend payment is essentially a guarantee that the stock will decline by a specific amount on a specific date, a high dividend payment on the horizon will translate to lower call premiums and higher put premiums.

But, because option prices are based on the performance of the underlying stock, a drop in the equity's price will still affect your option's price when it actually occurs. Let's say that XYZ was trading at $10 prior to the ex-dividend date, so a 7.50-strike call would carry intrinsic value of $2.50. However, with the stock dropping to $9 as a result of the dividend payment, the option's intrinsic value will automatically fall from $2.50 to $1.50. (Conversely, a 12.50-strike put option would gain a point of intrinsic value.)

Which brings us to dividend arbitrage, because wily traders have naturally concocted a scheme to benefit from these predictable price changes. In this strategy, you'll purchase in-the-money put options, along with 100 shares of the underlying equity for every one contract you buy. After collecting the dividend on the stock position, you'll exercise the option to sell the shares at the strike price of your put.

So, with XYZ still trading at $10, you would purchase 100 shares for $1,000. Simultaneously, you would buy a front-month, in-the-money put option -- let's say the 15 strike -- which is currently asked at $5.25. Your total cost is $525 on the put and $1,000 for the stock, or $1,525 total.

On the ex-dividend date, you'll rack up a dividend payment of $100 ($1 multiplied by your newly purchased 100 shares). Once you've locked in this payment, you can unload the stock position by exercising your put, which will allow you to sell the shares at $15 apiece. By selling 100 shares at $15, you'll take in $1,500 on the stock sale. Including the $100 you raked in on the dividend payment, that's $1,600 -- netting you a tiny little profit of $75 for your trouble. Less brokerage fees and commissions, of course.

There are those who would tell you that the low risk of arbitrage plays is sufficient to offset the low reward, but allow me to play devil's advocate for a moment. Arbitrage plays are theoretically "zero risk" only if you're trading in a laboratory environment, where all the variables can be controlled. Otherwise, there's a risk that changes in implied volatility or other factors could negatively impact your trade. And when you're dealing with such a low-reward strategy in the first place, there's not much room for error before your bottom line is going to take a hit.

In fairness, I'm not trying to paint dividend arbitrage as a high-risk trade. However, for the average retail-level investor, I'm simply suggesting that this strategy ultimately might not be worth the time, effort, and multiple transactions. Plus, because the potential profit is so slim, these types of trades are generally done in very high volume (think tens of thousands of contracts) in order to maximize the return -- again, putting this outside the realm of the typical trader's means.

Dividend capture

Having proven that I am definitely not trying to sell you on trading around dividends, let's take a look at another popular strategy: dividend capture. Rather than using stock and in-the-money puts, this tactic uses stock and in-the-money calls.

To capture dividends in this manner, you'll buy 100 shares of stock, and then write a covered call against those shares. This option should be in the money by a healthy amount, just as we used an in-the-money put for our arbitrage example. Sticking with XYZ, you'll write a 5-strike call against the 100 shares of stock. Assuming this option is worth $5.25, you'll rake in $525 for the sale of the option and shell out $1,000 for the purchase of the stock. The total outlay to enter the position is $475.

In order to minimize the risk of being assigned, it's best to play this trade just prior to the ex-dividend date. Once that date arrives, you'll be eligible to rake in $100 in dividends, so you're free to unwind your stock and option trades. You'll sell XYZ for $900, accounting for the $1 drop in the equity, and you can buy to close your option for $425. Adding it all up, you've taken in $1,000 by selling the stock and collecting the dividend, but you've spent $425 to buy back your short call. Your net is $575, for a profit of $100 on the position.

Again, of course, we are working in the proverbial lab environment here. Bear in mind that markets move fast, and you must be nimble in order to take advantage of minor price discrepancies and arbitrage opportunities.

But, whether you decide to trade around dividends or not, it's essential to know how these quarterly payouts can affect stock prices, option prices, and -- just as critical -- options activity around ex-dividend dates. When you see a stock swarmed by unusually heavy put or call volume, particularly at deep in-the-money strikes, it's worth checking on the company's ex-div date before you attempt to draw any sentiment conclusions from the activity.