How to Calculate an Options Contract When the Dividend Is Declared

An options contract is where an investor is given the right to buy or sell a stock in the future. It is not possible to calculate the exact price of an options contract upon a dividend payment, as its price is affected by the laws of supply and demand, which are in turn influenced by the movements of the financial markets. However, it is not difficult to know how the price of an options contract behaves upon the announcement of dividends. Call options always fall, whereas put options always rise in price.

Instructions

1. Determine if the options contract is out of the money (OTM), at the money (ATM) or in the money (ITM). The degree of movement of the strike price depends on the relationship between strike price and stock price. An option that is OTM means that strike price, or the price at which the option becomes valid, has not yet reached the stock price. ATM means that the strike price and the stock price are equal, and ITM means that the strike price exceeds the option price.

2. Note the size of the dividend payment as well as the stock's volatility. If you are unfamiliar with the stock's price movements and dividend payments, this information is often obtained from financial reporting websites. Stocks that are low in volatility and have high dividends tend to have a low call premium, and stocks that have high volatility in combination with low dividends have a high call premium. The call premium is the difference between the price of the options contract and the stock price.

3. Estimate the movement in price of the call premium. Once a dividend is paid, the price of the underlying stock always falls. This in turn affects the price of the options contract. If the options contract is ITM, its price will be the same as the stock, and hence its price will be the same as the underlying stock. If the options contract is ATM, the premium will drop, but not as much as that of ITM call premiums. OTM premiums also drop after a dividend is called, but drop even less than that of ATM call premiums. Furthermore, low call premiums will have a price closer to the stock price, and high call premiums will be priced further away from the stock price.

Tips & Warnings

• If your options contract is a put option and not a call option, the reverse is true. This is because, opposed to call options, put options give the right to sell, not to buy. When the price of stock falls, they become less desirable. Thus, the desire to sell put options becomes more desirable, and their option premiums increase.

References

• Callwriter.com; The Dividend Effect: How Stock and Options Prices React to Dividends; John Brasher; March 2005
• The Options Guide: Effect of Dividends on Option Pricing
• The Clark Financial Group: How Stock Splits and Dividends Affect Contracts
• OptionsTradingpedia.com: Effects of Dividends on Stock Options