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Why You Should Care About the Effect of Dividends on Option Prices

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Why You Should Care About the Effect of Dividends on Option Prices

In theory the value of future dividends should be reflected in the current price of a stock, which then determines the price of the associated options of that stock. However, the actual mechanics of dividend payouts means that their effect on the price of a stock and, thereby, its associated options is not necessarily intuitive.

Therefore, it is important that option traders understand exactly how dividend payouts work so that they can better predict the impact on the associated option prices.

Record Date and Ex-Dividend Date

Since modern stocks trade hands so often, it is essential that there is a system for determining who receives any dividend payouts on that stock.

The first important date in this process is the record date. The record date is the date where the owner of the stock will be the one to receive the dividend payout.

While this may seem simple enough, it does not account for the fact that stock clearing takes time, and someone who buys a stock on the record date will not be the official owner of that stock on the record date.

That is why the real date for dividend determination is the ex-dividend date, which is three days before the record date. To receive a dividend payout, an investor must buy the stock before the ex-dividend date to be the rightful owner on the record date.

Exchanges and Ex-Dividend Dates

This arrangement surrounding dividends and the ex-dividend date means that there are some implications for the price of a stock, and the associated options, on and before the ex-dividend date.

The crucial mechanic involved is the automatic reduction in the price of a stock performed by the exchange on the ex-dividend date. Since the value of the dividend on the ex-dividend date should be fully accounted for in the price of the stock, and anyone who buys the stock on or after the ex-dividend date will not receive the dividend, the value of the dividend is automatically deducted from the price of the stock by the exchange on the ex-dividend date.

For example, if the price of the stock on the ex-dividend date is $10 and the value of the dividend is $2, then the exchange will automatically adjust the price of the stock to $8 on the ex-dividend date.

The Implication of Dividends and Ex-Dividend Dates for Option Prices

When the automatic ex-dividend date adjustment is made, the price of the stock will drop by the value of the dividend. Since the value of the stock goes down, the value of any call options should go down leading up to the ex-dividend date, while the value of any put options should rise.

This result is counter-intuitive, where one would imagine that an upcoming dividend payout that generally increases the value of the stock should also increase the value of associated calls and decrease the value of associated puts.

However, once we understand the mechanics of the ex-dividend date and how the owners of call options on a stock do not receive a dividend payout, we can see why this counter-intuitive effect of dividends on option prices occurs.