I’ve had a number of people ask about the concept behind “Double Dip Dividends”
A good place to begin, is here.
In a nutshell some stocks have a little bit of a disconnect between the option premium and share price during the period of time that they’re going ex-dividend. What happens is that a portion of the dividend reduction in the share price is actually incorporated into the premium, when by all rights it really shouldn’t be. In effect the premium is enriched by an amount that partially offsets the reduction in share price as a result of paying the dividend.
People that refer to efficient pricing in markets conveniently overlook the particular advantages that can be had with regular dividend payments.
Note that I said “regular” dividends. The concept does not apply to special dividends that are greater than $0.125/share. In those cases the strike prices are adjusted downward to reflect the distribution of a special dividend, while such adjustment isn’t made in strike prices for regular dividends.
When stocks go ex-dividend there are some guidelines that can tell you whether your shares are likely to be assigned early if they are in the money as trading closes prior to going ex-dividend.
How far in the money are the shares?
The further in the money after deducting the amount of the dividend, the more likely they will be assigned.
How much time is still remaining on the contract?
The more time remaining the less likely you will see early assignment.
Obviously there are less clear cut combinations, such as being deeply in the money, but having lots of time remaining.
For example, a handful of people reported early assignment of all or some of their Cisco shares this morning which closed at $23.43 Monday evening and was paying a $0.17 dividend.
After deducting the dividend shares were still $0.26 in the money, although there was risk that shares could have traded lower today. On the other hand there were 4 days remaining on the contract.
Beyond those factors are individual considerations, such as how much the individual holding contracts paid for the contracts and whether that person could make more money by simply selling his contracts versus exercising the contract, collecting the dividend and then either selling or holding the underlying shares.
Let’s look at JP Morgan, which is trading ex-dividend tomorrow (October 2, 2013).
For those watching such things you may have noticed that in the final minute of trading on Tuesday, JPM shares went up $0.09 to end the day at $51.95. If you had sold the $51.50 option expiring on Friday, the critical share price would be $51.88, since the dividend was for $0.38.
Everything else being equal, you might see early assignments at JPM prices as low as $51.88.
But let’s dissect the situation further.
Since the October 4, 2013 $51.50 call option has been trading the lowest price anyone paid for it was $0.39, while the high price was $1.20
With shares closing at $51.96 on the day prior to going ex-dividend it’s price will be re-set $0.38 lower to $51.58 as trading opens on Wednesday October 2, 2013. That $0.38 decrease from Tuesday’s close to Wednesday’s opening in the pre-market represents the dividend.
Currently, the $51.50 option bid at Tuesday’s close is $0.47, which means that there is only $0.01 of time value, as the remainder is intrinsic value, as shares closed $0.46 in the money
Remember, just yesterday we sold calls at $0.52 when shares were trading at $51.65 ($0.15 intrinsic value, $0.37 time value). A portion of that time value was due to the dividend of $0.38, however at a share price of $51.65 no rational person would exercise early to get the dividend and end up holding shares the following morning priced at $51.27 that he had to pay $51.50 to obtain and also paid a premium to purchase the options.
So from an option holder’s perspective when would it make sense to exercise the option early?
Assuming you can sell the shares for $51.58 tomorrow morning that represents an $0.08 profit from the $51.50 strike price that they paid when exercising. Add to that the $0.38 dividend to get a total of $0.46 profit.
But the lowest anyone paid for the right to do any of this was the $0.39 option premium meaning that there would be a potential for only $0.07 profit for those that timed it just perfectly.
But that profit margin, available only to some of those having bought options assumes that shares will open at least at $51.58 or higher. What the person considering the early exercise thinks about is also what is the chance that once I take hold of shares it will go down in value before I have a chance to sell the shares? Is it worth the $0.07 profit or even less?
The closer the opening price will be to the strike price the greater is that likelihood, which means taking a loss on the shares in which they just took ownership. On top of that is the cost incurred in having to purchase shares. Remember that option buyers typically find great appeal in leveraging their investment, perhaps by 10 times or more. They don’t get much delight in buying stocks, even if only for minutes, if it means introducing portfolio risk and only getting 2x leverage.
So while JP Morgan essentially closed $0.08 in the money that makes it a risk factor for early assignment.
But there are still 3 days left on the contract. That argues against assignment.
After that it becomes luck of the draw. How much did your contract holder pay for his contracts? Anyone who paid more than $0.46 for their options would have been better off closing their position by selling the contract for $0.47 than to exercise early.
The likelihood is that there are more options holders who purchased their options at prices greater than the low point of $0.39, so the number of individuals in a position to rationally act and exercise early would be relatively small.
My expectation is that most people will not be subject to early assignment, but I did find the last minute surge in share price very curious and made me wonder whether it was related to the ex-dividend date.
Occasionally you will also see early assignments that are completely irrational and less occasionally not see early assignments when they would have been completely rational. You can be certain that those were always products of an individual investor. While one is maddening, the other can be a nice surprise..
For those wondering about Cisco, the lowest price paid for the October 4, 2013 $23 options was $0.20. If selling shares at $23.26 that would have represented possibly a $0.26 profit (if shares didn’t head lower), plus $0.17 dividend, minus $0.20 option premium paid yielding a potential $0.23 profit per share. Of course the high price paid for option contracts was $1.18. For those paying anything more than $0.43 for their options they would have been better off simply trading out of their position and closing their option rather than trying to capture the dividend and assume the risk of ownership.
While having early assignment can sometimes be frustrating, especially when there is a last day surge in share price, as occurred with Dow Chemical last week, when able to capture both the dividend and a premium enhanced by the pricing inefficiency it is a thing of beauty.
Wednesday Morning Postscript: The first thing I do on ex-dividend mornings is to check to see whether I still have all of my shares. In this case the JPM shares have stayed intact. For anyone who decided to exercise their options the pre-market is indicating a loss of $0.27 bringing shares to $51.31. Suddenly, the thin profit that a small portion of option buyers deciding to exercise thought they had last night has become a paper loss and they would find themselves regretting the decision to exercise for the sake of securing the dividend. Holding the security for a option buyer means that at least $2575 of his money is now tied up and possibly generating margin interest costs and is unable to be further leveraged in order to buy more option contracts.
Most rational contract holders would have considered that possibility very strongly before making the decision and would likely have opted to not exercise, as a result.