"dividend risk" when trading options.. what are they?
i read about dividend risks when you trade options around dividend ex-date and other key dates.. never was able to digest what i read.. can someone please explain in simple terms..
is there a scenario where you pay (vs receive) the dividends if you're on the option's short side? or did i get this wrong? thx
Here's the deal, you have to be long the stock on the ex-date to collect the dividend. (long a call option on the stock provides no dividend rights) If you are short an option that is in-the-money at ex-dividend you may be required to deliver 100 shares of stock at the strike price. (This is because owners of the call options are exercising their rights, they want to take delivery of 100 shares of stock to collect the dividend. Hint- If you want to avoid all this, trade European style options... (such as the Rut or SPX).
@optiontrader767, yes, i get this part .. "If you are short a [CALL] option that is in-the-money..." .. i have to deliver the stocks if they're "called" .. if i'm short an ITM PUT, i have to take the stock (the stock is PUT to me) and pay the strick price which will be higher than current market price.. (been thru both from short side before)
but where exactly is the "dividend risk" .. ? if in the scenario of a short CALL and comes ex-date, do i deliver the stock and *also* pay the call buyer the diviends on top of that? that's the part i'm not clear about...
The only time you have to pay the dividend is if you are short the stock. By short I mean you borrowed the shares from your broker (sold them) with the intent to buy them back later at a lower price. (I think this is a "weak sauce" out-dated strategy).
If you are "called out" you have to deliver stock. This means you must have the cash to buy 100 shares (in the market) in order to deliver them. (100 shares per option contract) Or you must in turn exercise one of your long options to get the stock. Remember, when you first purchased that long option (the one I mention in the previous sentence) you paid "extra" for the time value. If you exercise it, you lose any time value that remains in that option... this is risk.
Look at the other side... If you are thinking about exercising an option to "get stock" to collect a dividend, you have to weight the dividend amount that you will receive to the time value you will lose.
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The dividend risk applies when you are short deep in the money American options. If the dividend is worth more than the time premium of the options then the long may exercise the option right before the ex-dividend date to acquire the stock and receive the dividend which he would not get from just holding the call.
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