Dividends and Their Effect on Options
We covered earlier that ordinary cash dividends don't adjust option contract terms. But dividends still have a significant impact on options: they affect premiums and create the most common scenario for early exercise. This is one of the most frequently tested options topics on the Series 7.
Ex-Dividend Date Impact on Premiums
On the ex-dividend date, the stock price typically drops by approximately the dividend amount. This price change ripples through to option premiums:
| Effect | Call Premiums | Put Premiums |
|---|---|---|
| Stock price drops on ex-date | Decrease (calls less valuable when stock falls) | Increase (puts more valuable when stock falls) |
- These changes are anticipated by the market and reflected in premium pricing before the ex-date
- The contract terms (strike price, contract size) do not change; only the premium adjusts based on supply and demand
Exam Tip: Gotchas
- Cash dividends don't change contract terms but DO affect premiums. The strike price and contract size stay the same; only the premium moves.
- Calls decrease in value around ex-dates; puts increase. The stock price drop on the ex-date hurts call holders and helps put holders.
Early Exercise Risk Around Dividends
The most common reason for early exercise of an American-style call option is to capture an upcoming dividend.
Here's the logic:
- A call holder has the right to buy stock but does not own the stock
- Only stockholders of record receive dividends
- To capture the dividend, the call holder must exercise the option and take delivery of the stock before the ex-dividend date
When Early Exercise Is Most Likely
A call holder is most likely to exercise early when all three conditions are met:
- The call is deep in the money (high intrinsic value)
- The remaining time value is less than the dividend amount (exercising forfeits time value, so the dividend must be worth more)
- Expiration is relatively near (less time value remaining to forfeit)
Timeline
- The holder exercises the call on the day before the ex-dividend date
- By exercising, they take ownership of the stock and qualify for the dividend
- The writer of that call faces elevated assignment risk the day before the ex-date
Exam Tip: Gotchas
- Early exercise happens the day BEFORE the ex-date, not on the ex-date. The holder must own stock before the ex-date to qualify for the dividend.
- Time value must be less than the dividend for early exercise to make economic sense. Exercising forfeits remaining time value, so the dividend needs to exceed that amount.
- Short call writers face the highest assignment risk right before the ex-dividend date. If your short call is deep ITM near a dividend, expect assignment.
- Early exercise of American-style calls almost always relates to dividend capture. If a question asks "When is a call most likely to be exercised early?", the answer is: the day before the ex-dividend date on a deep in-the-money (ITM) call where time value is less than the dividend.