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Friday, November 21, 2014

Understanding effect of special dividend on option prices

As traders across the world have begun to accept the reality that the stock market does not rise by an average of 10% per year, they have begun to look for different ways to invest their money. One of these ways involves buying stocks that pay dividends. As the dreams of a 10% annual gift wane, they are replaced by a new landscape in which investors are willing to take on the risk of stock ownership in exchange for a dividend payout in the range of two to two-and-a-half percent per year! Of course, while most dividends are paid on a defined quarterly schedule, some dividends are paid on a more sporadic basis. Such dividends, typically paid “on a whim” are called special dividends, and they behave somewhat differently from the standard quarterly type.
What is a Special Dividend?
Unlike standard quarterly, or otherwise periodic dividends, a special dividend is one that is not part of the corporation’s dividend program. Therefore, a special dividend cannot be anticipated or assumed beyond the one-time occurrence. Because there is no assumed stream of payments with special dividends, future special dividends cannot be factored into standard option prices.
Contrary to the relatively small but consistent payment stream associated with regular dividends, special dividends tend to be larger one-time payments. As such, the Options Clearing Corporation (OCC) has developed a separate protocol to deal with such payments so that option investors are not adversely affected by the large change in the stock’s value due to the large payout.
How Are Options Affected by Special Dividend Payments?
There are many ways in which the OCC may adjust options in order to ensure investor safety. One of the more common ways to adjust options for a special dividend is to change the option strikes by the amount of the dividend. This can be a confusing concept for new options traders, so to illustrate, let’s take the case of Costco (COST), currently trading near $106 per share. COST issued a special dividend valued at $7.00 per share. The ex-dividend date was December 6, 2012. The following option chain shows front-month COST options on December 5 – the day before the ex-dividend date.
Most dividend investors know that when a company pays out part of its value in the form of a cash dividend, it follow that the company’s per-share value must drop by the dividend amount. After all, the money to pay the dividend can’t come from thin air!
So, the easy conclusion here would be to think that with the stock near $106 per share, and with an upcoming special dividend on the order of $7.00 per share, the expectation is that on the ex-dividend date, COST should be trading around $99 per share, all else equal.
Here’s the key…if the OCC did not adjust COST options for the upcoming special dividend, then it would open the doors for the following simple strategy: A trader could buy the December 105-strike puts, currently trading for $1.60, and when the stock was adjusted to around $99 per share on the ex-dividend date, those very same puts would be worth at least $6.00, since that’s the amount that they would be in-the-money.
But look at the option chain shown below to see what actually happened to the 105 puts on the ex-dividend date:
On the ex-dividend date, COST dropped from $105.9483 to $98.47. This would normally represent a change in stock value of $7.4783. But if you look at the net change on the day, it is only $0.4783. The other seven dollars are not considered part of any daily change because they are simply an adjustment that had to be made to reflect that part of the value of the stock was returned to the stockholder via the special dividend.
Hey! What Happened to My Options?
Umm, yeah, regardless of what happened in the stock, aren’t my 105-strike puts almost $7.00 in the money? Well, not really. You see, the OCC adjusted the strike on the COST options to reflect the adjustment in the stock price due to the special dividend. Therefore, the 105-strike was also adjusted by $7.00 and it became the 98 strike. Due to the slight drop in the stock on the day, the put options are priced slightly higher, but nowhere near the level that an inexperienced options trader might have expected.
A Few Concluding Remarks
So the search for the free lunch continues. If you were a COST shareholder prior to the ex-dividend date, the value of your stock was adjusted lower by $7.00 per share, but you received a payment on the order of $7.00 per share via a special dividend. If you bought COST after the ex-dividend date, you did not get the special dividend, but you were able to buy COST shares roughly $7.00 cheaper than what you would have had to pay prior to the ex-dividend date.
As for the options traders, namely those hoping to make it big with the purchase of the December 105-strike puts, you were big winners, as you learned a valuable lesson in the way option prices take dividend values into account in order to ensure market stability. The more education you have, the less dangerous a trader you become.

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