What is options trading dividend risk? (US options and futures)

When a trader purchases a call option and there is an upcoming dividend, it can potentially yield a risk-free profit to the owner of the long call if the corresponding put costs less than the upcoming dividend amount. For example, let's say you are the owner of a $100-strike call and the upcoming dividend is $1/share ($100 total) and the corresponding 100-strike put cost $0.25 ($25 total). Well, the owner of the call can turn this into a risk-free profit by exercising the call before the ex-dividend date and simultaneously purchase the corresponding put, resulting in a $75 profit ($100 dividend payment - $25 cost of the put).

ITM vs. OTM calls

Dividend risk can affect all options strategies that have a short call component. That includes long or short call spreads, iron condors, calendars, diagonals, strangles, straddles, etc. especially when the corresponding put of the short call is lower than the dividend amount. That said, ITM calls generally have a higher potential of dividend risk than OTM calls.

Before we dive into an example, let's define what an ex-dividend date is since that is typically when investors with short calls may be assigned. The ex-dividend date, or ex-date, is now the same as the record date due to the T+1 settlement change. Investors that wish to receive the dividend need to purchase the stock before the ex-dividend date to be recorded as an owner of the shares to receive the dividend.

Example Stock Record date: Tuesday

Example Ex-date: Tuesday

Due to the T+1 stock settlement time, the last day to purchase the stock or exercise a long call(s) to be entitled to the dividend is Monday, the trading day before the ex-date.

Since ETFs are a basket of stocks wrapped in a single share that tracks an index or sector, such as following the S&P 500 (SPY) or technology sector (XLK), the composition or weighting of the ETF to specific underlyings may have changed since the last dividend payment.

As a result, the dividend amount cannot be accurately determined. You may refer to the last dividend paid in quote details inside the right-hand side bar of the trading platform. Or, you may view prior dividend payments by visiting the investment company's website to get a rough idea, but it may not be consistent. Note that ETF compositions may change, resulting in varying dividend amounts.

Low dividend risk vs. high dividend risk:
Now, let’s look at two examples concerning a real-life symbol - MCD (McDonald’s Corporation). The first is a naked call position that presents potential dividend risk and the second is another naked call position that presents little to no dividend risk. BOTH screenshots were taken at the SAME time on Wednesday, May 31, 2017, with MCD going ex-dividend on Thursday, June 1, 2017 (the next day).

• Price: $151.00
• Dividend amount: $0.94/share
• Ex-Dividend Date: Thursday, June 1, 2017 - the date when MCD trades without a dividend.

Low dividend risk:
In this example, the value of the dividend does not exceed the put value. Despite the 150 call being in the money, the amount of extrinsic value in the puts makes this a scenario that presents little to no dividend risk to the portfolio-holder.

High dividend risk
This is a great example of an ITM call that presents high dividend risk. In this case, the $0.94/share dividend that McDonald’s plans to pay out greatly exceeds the put extrinsic value, which is $0.055 (mid-price). Chances are that this portfolio will be assigned 100 short shares of MCD at $135 and owe a dividend of $94 ($0.94 x 100) when the dividend becomes payable on June 19, 2017.

One preventative measure you can take to reduce the possibility of facing dividend risk through assignment is to roll short ITM calls for a credit to a further date. This compounds extrinsic/time value on the call and ultimately buys time for the relevant put value to become greater than the dividend value. You can also choose to close the short call by buying it back and accepting the loss, which at least releases you from the obligation of paying the dividend on the dividend payable date (if assigned).

If you were assigned short stock before the ex-dividend date then you will owe the dividend to the counterparty on the dividend payable date. Let’s continue our McDonald's example and take a look at what happens when the dividend is due and paid out after being assigned short stock.

In the example below, this account was assigned 100 short shares at $135 before the ex-dividend date. McDonald’s declared its dividend payable date as June 19th. This means that the dividend will be paid out on that day. Since this account was assigned short stock before the ex-dividend date then this account will be debited the total dividend amount of $94 ($0.94 x 100 shares) on the dividend payable date, as illustrated below.

Important note:

All American-style short option positions you hold can be exercised at any time by their long holder, regardless of whether or not the exercise benefits them financially. This is generally important to keep in mind when you trade options.