Call options give the option holder the right to buy the underlying stock at a specific price. If the stock is projected to pay a dividend before the option expires, the dividend payment will affect both the stock and option prices. Option traders must understand the effects of a dividend payment on the call options they own.
Dividends and Stock Price
When a stock pays a dividend, the stock price drops by the amount of the dividend on the ex-dividend date. Investors who purchase shares before the ex-dividend date receive the dividend. Those who buy on the ex-dividend date or later will not receive the distribution. For example, a stock is at $50 per share the day before the ex-dividend date of a $1 payout. On the ex-dividend date the share price will open at $49 per share.
Call Option Values
The value of a call options is based on the underlying share price. Option traders know the stock value will decline on the ex-dividend date, so the price of a call option on a dividend paying stock will be lower than if the stock was not going to pay the dividend. The decline in option price may lead the ex-dividend date by days or weeks. On the ex-dividend date, a call option may decline slightly in value, but the drop may not be as large as the decline in the stock price.
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"Moneyness" is the relationship between the strike price of a call option and current price of the underlying stock. The strike price is the price at which a call option holder buys the stock if he elects to exercise the contract. If the stock price is above the strike price, the call option is in-the-money. If the stock price is below the strike price, the option is out-of-the-money. The further an option is in-the-money, the greater the effect of the ex-dividend share price drop on the option price. Far out-of-the-money call options will sell with little effect from the ex-dividend share price change.
Call Option Choices
The holder of an in-the-money call option can elect to exercise the call option and buy the stock before the ex-dividend date. The trader would then collect the dividend and avoid the loss associated with the drop in value of the option due to the ex-dividend date. If the call option has significant premium value above the in-the-money amount, a more profitable trade may be to sell the call option and buy the stock directly to collect the dividend.