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Today’s foray into the realm of options education addresses a widely used stratagem known as dividend capture. And while it could be considered a covered call “alternative,” it might be more accurately labeled covered call “related,” since it uses the covered call structure not as a strategy in its own right, but rather to achieve a particular, unrelated goal.
Confused? Not to worry! It will all come clear.
Stock Movements When Dividends Are Paid
There’s a peculiar occurrence among stocks that pay dividends that all options traders should be aware of. It involves the sudden drop in price of a stock directly after the ex-dividend date by an amount commensurate with the size of the dividend.
Why does it occur?
The market adjusts for every possible variable that contributes to a stock’s valuation. So, if a fat dividend is on offer, there would be nothing to stop a smart investor from purchasing the stock prior to the ex-dividend date and selling it immediately after in order to “capture” the dividend, so to speak, without risking long-term possession of the stock.
The market therefore compensates for this eventuality by selling off immediately after the dividend is awarded by at least as much as the dividend amount. That negates any possible gain on the part of the dividend “thief,” making the tactic a futile exercise that contributes only to his commissions paid.
But options traders can win.
There is a technique that permits options traders to effectively capture that same dividend, and it goes like this:
- On the day before the stock goes ex-dividend, you buy 100 shares of the underlying. That establishes your right to the dividend.
- At the same time, you sell one deep-in-the-money call option against the shares. You go deep-in-the-money because such options possess what we call a “delta” value close to 1. That is, for every one dollar move higher or lower in the stock, so, too, will the option move a dollar higher or lower.
The importance of that last point will become clear in the example below.
Reality Is the Best Teacher
Let’s imagine you want a piece of the latest dividend from Gargoyle Teeth Enhancement, worth $1.80 to all shareholders of record on Nov. 12.
One that day you therefore purchase 100 shares of Gargoyle at $60, for a total debit of $6,000.
You also sell the near-month 48 call for $12.40.
The following day, Nov. 13, the stock goes ex-dividend, and, as expected, the shares drop by $1.80 to $58.20. Your deep-in-the-money call also drops by that amount to $10.60 ($12.40 – $1.80). You therefore register a loss of $180 when you sell the stock, but gain $180 on the short sale of the option.
That results in a net zero takeaway from the trade of the two securities – but since you’re a registered owner of the shares before the ex-dividend date, you’re still entitled to your $180 payout!
One Caveat
There is a small risk that your in-the-money call could be assigned early, in which case your shares will be called away and you won’t be eligible for the dividend.
Keep in mind, too, that the more distant an option is from expiry, the less chance there is for early assignment. A very careful investor might therefore consider selling not the near-term expiry, but one further out.
Best of luck!
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