How dividends impact options assignment risk & how to avoid it

Published on Saturday, October 13, 2018 by Chittorgarh.com Team | Modified on Wednesday, July 3, 2019

Many profit-making companies announce dividends every year. A dividend is an act of gratitude towards the shareholders for reposing faith in the company. It also acts as an extra incentive to be invested or invest in the company. But do you know that dividend announcements also impact the stock Options of the company? In this article, we will discuss how dividends impact Options pricing and its effect on assignment risk.

What is a dividend?

A dividend is a part of the profits, paid as cash, annually to the shareholders. The dividend is announced on a per share basis. For example, if you own 1000 shares of a company that announced a Rs 3 dividend per share then you will receive Rs 3000 as a dividend.

Not all companies pay dividends. Normally, it is believed that dividends are paid by companies that have passed their growth stage and their share price cannot move beyond a certain range. Such companies give dividends to keep their investors happy and make the stock attractive to new investors.

For investors, dividend means stable returns every year. Many long-term investors factor in the dividend history of the company while investing in it.

How dividend impact Option contracts?

Option contracts are derived from the stocks of the company and move in direct relationship with each other. So when the stock prices move up, its Options value also increases and vice versa. You will find 3 things happening at the time of dividend announcements-

• A short rally ahead of the company announcing the dividend
• Significant selling on the day and after the announcement
• The price of the share fall after the announcement

This sudden increase in the price of stocks of the company and its Options makes the field uneven for people taking positions in the Options market at that time. To bring parity for all and to ensure that the value of the trades taken before the dividend announcement remains as close as possible, exchanges do Options adjustment. SEBI has laid out guidelines and suggested formulas for Options adjustments.

How dividend announcements affect assignment risks?

Options traders are not entitled to receiving dividends. This increases the assignment risk for anyone who has sold Option contracts in the period. How? We will learn it in a while but first, let's discuss in short some important dates related to dividends-

• Declaration date of the dividend
• Record date to find eligible shareholders
• Ex-dividend date which is 1 trading day prior to the record date
• Payment date when the dividend is credited into the account of shareholders

The role of the ex-dividend date is important in the case of Options contracts. The ex-dividend date is 1 day prior to the record date. People who are shareholders of the company on the record date are eligible for dividends.

When the market opens on the ex-dividend date the stock of the company will open at an ex-dividend price. So, if you want to to be eligible for the dividend then you will have to buy the stocks on a day prior to the ex-dividend date so that you can get the delivery on the record date.

For example, suppose the company announces 23rd April as the record date, now the ex-dividend date will be 22nd April. So, a trader needs to buy the share on 21st April to get it delivered on 23rd April and be eligible for dividends.

The record date determines the eligible shareholders to receive dividends and the day prior to ex-dividend date determines the last opportunity to buy the stocks to receive the dividends.

This increases the likelihood of assignment risk to traders who have sold their Call Options. Let's understand this with an example-

Vivek (imaginary name) owns 1000 shares of a Bank, which announces a Rs 5 per share dividend. The stock was trading at Rs 200 a share when Vivek sold 5 lots of the contract. By the time dividend announced the stock price rose to Rs 230. The call will expire in the next 7 days.

In such a scenario, the Call buyer realizing a profit in the trade may exercise the contract a day before the ex-dividend date.

In such a case, Vivek will have to deliver 5 lots of shares and he will also not receive the dividend announced. The losses may become huge if Vivek has taken uncovered or naked position i.e. selling without holding the shares.

To avoid this scenario, Vivek has to close his position by either-

• Taking a reverse position i.e. buying 5 lot of the contract at the same strike price and expiry date
• Take the reverse position explained above and take a new short position with a different strike price and expiry date

How to avoid Options assignment risk due to dividends?

There are some simple ways to avoid getting assigned on ex-dividend date like-

• Carefully take positions during dividend announcement period
• Keep an eye on the announcements of the company you are trading
• Avoid taking uncovered positions during the period
• Take positions in European style Options as they can only be exercised on the expiry date