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Contract Adjustments for Special Dividends When Trading Stock Options

Filed Under Beginner Options Trading 

As with any option adjustment, there is nothing you need to do, since all adjustments and symbol changes will automatically take place in your account.
 
There is nothing necessarily wrong with trading adjusted options; in fact, in some situations you have no choice. If the ABC $180 call undergoes a 2:1 split, it will be adjusted to a $90 strike. This is technically an adjusted option because it was once a $180 strike and it is now the $90 strike. However, it still controls 100 shares and in all other ways behaves just like a regular unadjusted option. If you wish to trade the $90 strike, you may have no choice but to trade the “adjusted” contract. Just be sure that you understand what that contract represents and that it matches your goal.
 
Stock splits are not the only event that causes option adjustments. Mergers, acquisitions, special dividends, and other forms of corporate activity and restructuring will cause adjustments. Under these scenarios, some adjusted options can get complex and control differing amounts of shares plus shares of another company plus cash. For example, in 2004, Motorola (MOT) announced that all owners of record on November 29 would receive a distribution of Freescale Semiconductor (FSL.B). All options affected by the distribution would be adjusted to control 100 shares of Motorola, 11 shares of Freescale Semiconductor, and 76 cents cash. Most traders avoid adjusted options that control numerous assets like this because the liquidity (the number of contracts available in the market) tends to be low. After all, why would you want the right to buy or sell 100 shares of Motorola, 11 shares of Freescale Semiconductor, and 76 cents in cash? So as a general rule, avoid entering into adjusted options with complex structures unless there is a very good reason you need that specific contract.
 
 
Contract Adjustments for Special Dividends
Many stocks pay a dividend, which is simply a cash payment to shareholders usually made on a quarterly basis (sometimes it is paid semiannually). In some cases, dividends may cause strike price adjustments so it’s important to understand when and why these adjustments occur.
 
If a stock pays an eight-cent dividend, that really means eights cents per share per year. If you own 100 shares, you’d receive a total cash deposit of $.08 * 100 = $8 per year. But because dividends are usually paid on a quarterly basis, you’d actually receive four payments of $2. Dividend payments are usually deposited electronically to your brokerage account.
 
The stock’s price is always reduced by the amount of the dividend on the date the dividend is paid, which is called the ex-date. The ex-date is simply the date that the stock trades “ex,” or “without” the dividend. For example, assume a $100 stock pays a $1 dividend tomorrow. The stock will open tomorrow for trading at $99 unchanged. Even though the stock’s price is technically lower, that is due to the payment of the dividend and not a factor between supply and demand. Think about it this way: If you have a jar of 100 one-dollar bills, it is worth $100. If you take one dollar out, the jar is now worth only $99. This is exactly what happens with corporations when they pay a dividend. The value of the stock is comprised of all assets of the company, one of which is cash. If one dollar is paid to each stockholder, the total value of the stock must be reduced by the amount of that payment, which means the stock would now be worth $99. Just remember that the value of the stock is always reduced by the amount of the dividend on the ex-date.
 
Most companies that pay dividends pay them on a regular basis. These regular dividends do not cause option strikes to be adjusted. The reason is that the market knows about these dividends well in advance and they automatically get factored into the option’s price.
 
Sometimes, however, corporations pay a special one-time dividend and, in these cases, they do cause adjustments to option strikes. Whenever a special dividend is announced, all call and put strikes are reduced by the amount of the dividend. For example, on July 20, 2004 Microsoft announced a special $3 cash dividend. This was a special one-time dividend so the option strikes – calls and puts – were adjusted downward by the amount of the dividend. If you were holding the $30 call, it became a $27 strike. If you were holding the $30 put, it also became a $27 strike. Why does this happen? Again, any adjustment in option strikes is done to assure that option investors are not financially hurt (or unfairly rewarded) because of a corporate action such as a split, merger, or even a special dividend.
 
By reducing all strike prices by the amount of the dividend, calls and puts retain all of their intrinsic value after the split. To show how, imagine that Microsoft is trading for $35 and that you own the $30 call that is worth exactly the $5 intrinsic value just prior to the payment of the $3 dividend. On the ex-date, the stock’s price will be reduced by the dividend and will open for trading at $32. With the stock at $32 though, your $30 call will only be worth $2, which means the value of your call dropped from $5 to $2 for no reason other than the fact that a special dividend was paid (call prices fall with a drop in stock price). In order to keep the $30 call holders from unfairly losing $3, the strike is reduced by the amount of the dividend to $27. With the strike at $27, your option is still worth the $5 intrinsic value when the stock opens at $32.
 
Now let’s work through an example with a put option. Think about a $40 put that is trading for the intrinsic value of $5. On ex-date, the stock price is reduced from $35 to $32, and the option’s price jumps to the $8 intrinsic value. In this case, the put holder unfairly benefits from the reduction in the stock’s price (put options benefit from a drop in the stock’s price). However, if that strike is reduced by the dividend to $37, it will be worth $5 with the stock at $32.
 
In both cases, the calls and puts are worth $5 before the ex-date and after due to the adjustment. In other words, the special dividend does not affect their pricing. When you think about it, the special dividend should not affect option prices since it doesn’t really affect the holder of the stock. While it appears that the owner of 100 shares of Microsoft gets a nice $3 “bonus,” you must remember that the price of Microsoft will also fall by $3 on ex-date. The owner of Microsoft receives $300 cash but loses $300 in stock value, which is a wash. In other words, stock holders were not really affected negatively or positively but only the form of their wealth has changed. If stock holders are not really affected by the special dividend then why should option holders be subjected to unfair increases or decreases in wealth? Of course, they shouldn’t be, and that’s why the strike prices are adjusted.
 
You might be wondering if there’s a way to get some “free money” from the markets by buying a call and then exercising it to collect the dividend. The answer is no, since you will always pay a time premium for the call. Once you exercise the call, you lose the time premium so you’d always be better off just buying the stock in the open market. For instance, let’s assume the Microsoft $50 call is trading for $2. If you pay $2 and then immediately exercise it, you will pay $50 and receive 100 shares of stock. However, you paid $2 for the option, which means you effectively paid $52 to gain the stock. You could have just purchased the stock in the open market for $50 and paid one commission to do so. Whenever special dividends are announced, especially large ones, you will hear all kinds of option “strategies” that allow for some type of arbitrage. These are simply false rumors, and the reason they won’t work is twofold. First, time premiums make it more costly to buy the stock. Second, the strike prices are reduced on ex-date.
 
Just remember that stock prices are always adjusted when dividends are paid. In the case of special dividends, option strike prices will be adjusted too. The previous section talked about stock splits, which we said are technically dividends. Rather than receiving cash though, investors receive shares of stock. If a stock does a 2:1 split that is really recorded through the brokerage firm as a one-share dividend for every share owned. What does that do to the stock’s price? Just as with cash dividends, it reduces the price of the stock. If you receive one share of stock for every share you have, the company has, in fact, paid half of its value back to shareholders and that means the share price must fall by half.
 
To be continued……

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