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.
"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.