Take a second and think back to when you first learned about dividends. At some point, most of us have probably asked ourselves one very similar question: can we buy shares right before the ex-dividend date, collect the dividend, and then sell the shares immediately afterwards for a profit?
If you’ve tried this little scheme, then you’ve likely discovered a disappointing reality. On the ex-dividend date, the share price of the equity decreases by the value of the dividend. However, trading call options provides us with a unique opportunity to try and capture a risk-free profit as the stock goes ex. The trade will be constructed around the writing of covered calls. Obviously, we will need to find a stock with an approaching ex-dividend date, and a desirable dividend amount.
The process is as such:
- Calculate the intrinsic value of a deep in-the-money (ITM) call based upon the spot price in the equity, and then add the premium of the corresponding strike put.
- Assume that you can sell the call at the cumulative price. Realistically, you are going to have to offer this call and/or look for a bid that satisfies the required cumulative premium if the spot price of the equity changes, which it will.
- Per each call sold, buy an amount of shares equal to the option’s multiplier (typically 100, unless you are trading mini or jumbo options) at the reference spot price used to calculate the intrinsic value. Make sure you can trade the equity at this price or better. If you cannot, you must cancel your call offer and/or do not hit a bid in the call that you have been eyeing.
- You are now long the equity and short a 100 delta call. Essentially you just executed a buy-write. The stock and call will change in value equally with every tick. You are hedged and will just have to wait for the results on the ex-dividend date (which is assumed to be tomorrow). You can obviously construct this trade before the ex-dividend date, but that just adds extra time for the calls to be assigned to you. But you may also be able to sell more time value in the call.
On the ex-dividend day, if you did not receive a notice from your broker that you are being assigned on your short calls, then you will receive the dividend. Receiving such a notice might possibly occur in the event that a large percentage of counter-parties forgot about the dividend, or it was a surprise dividend not widely known. Otherwise though, your position will remain until expiration, or until you find an opportunity to buy back the call and sell the equity.
The caveat to this strategy is that buyers will typically early exercise the contracts. If this happens, you will no longer receive the dividend from the underlying. When the buyer of a call exercises her right to own the stock, she technically purchases the equity on that trading day and qualifies for the dividend. That dividend right becomes your obligation, which is offset by your long stock.
However, you will still come out on top if there was some time value remaining on the corresponding strike put. When the call is assigned, you are essentially buying back a short option. Your long stock position should offset the combined value of the strike price of the call and its intrinsic value. If the long stock price minus the strike price is less than the price of the call sold, then you’ve made some extra money (i.e. the time value of the put). Even though that premium may be much less than the free dividend that you were hoping for, it’s still free money. That is, as long as your transaction costs were not greater than your consolation prize.
We will conclude with a quick example.
Let’s say we have decided that company “X” is paying a cash dividend that we would like to capture. The ex-dividend date is set for the last day in October, Aka Halloween. The yield of the dividend is set at 5%, and company “X” is trading at $50 per share. Therefore, the cash dividend will be $2.50 per share acquired (50 x 0.05 = 2.50). On October 30th, we will purchase 100 shares of company “X” for $50 ($5,000 capital). On that same day we will also write (sell) 1 40 call of company “X” and collect a premium of $10 ($1000 capital).
On Halloween (the ex-dividend date for company “X”), the price of company “X” drops by $2.50 per share from $50 to $47.50. Since our call was deep in the money, the price of the 40 calls we sold also drops by a similar amount to $7.50. The next day, the buyer of our calls has not exercised them. Springing into action, we sell our shares of company “X”, now worth $47.50 ($4750 capital), and buy back the calls we sold for $7.50 ($750 capital). Shortly thereafter, we receive our cash dividend and conclude our trade with a profit of $250.
(Image Credit: Chris Potter)
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