Beware: Call writers must pay dividend

Discussion in 'Options' started by Option Trader, Oct 31, 2005.

  1. If the calls you wrote go in-the-money just before ex-dividend, and you don't have the underlying stock, it is common for the calls to be exercised (the day before ex-dividend) and you will have to pay the dividend out of your own pocket as if you were short the stock! I.e. call calendar spreads, bear call credit spreads, etc. must do their research. Buying the stock to cover the next morning will be too late!

    Brokers do a terrible job regarding disclosure of this point, and the rule is a bit insane, because in ever other way (e.g. notice to you, margin requirements, etc.) only begins the next day. If this ever happened to you, I may have an attorney and expert witness lined up for you. You can send me a message.
  2. Quote from Option Trader

    That's a new one on me. In the UK the contract is to deliver the stock, nothing else.
  3. I think you mean European style options as found on index options, as they cannot be exercised early.
  4. No, American style individual equity options traded on LIFFE - contract is to deliver the stock.... only.
  5. Knew one to me. Thanks
  6. def

    def Sponsor

    option trader,

    this is standard options theory and the probability of getting assigned is quantifiable (ie. via simple math you can determine whether or not it is worth exercising an option before the ex-date).

    The basics:

    If a stock goes ex-div tomorrow, they are exercising the option on t-1 (i.e. today) because - all things being the same - on the open tomorrow the stock will drop by the amount of the dividend. Thus upon the record date of the dividend, they will be long the stock and the person shorting the option who got assigned will thus be short the stock.

    Now the good news, assuming you shorted at a fair price, the amount you pay in dividends was priced into value of the option. As a result the act of getting assigned didn't cost you money as you already "received" the dividend.

    as for liffe, I'd be surprised it is handled any differently. i.e. if you are short the stock on the ex-date you'll have to pay the dividend.
  7. Def

    Yes, thinking about the mechanics of it you're absolutely right.

    What I should have said was .... being exercised over ex-div date won't cost the short call writer a dividend. See Def's cahsflow above.
  8. Correction: T+1 merely means the amount of time for settlement, for non-dividend purposes. E.g. ex-dividend is 3 business days before settlement date, seemingly chosen because stocks are T+3. But acc. to that, the concern of early exercise for options which are T+1 should be till the day before settlement date--but that is not the case.

    The reason for the obligation is a bit unfair, because OCC gives instant entitlement to the stock upon exercise of the options, and with all its entitlements to dividends, while the writer, who thought he could cover for himself the next day, loses the dividend. It does not help that the stock value goes down equally, because that means the calls you are long on also went down in value.
  9. def

    def Sponsor

    you've got the mechanics wrong. the obligation is not unfair because it is priced into the value of the option.
  10. It is partially factored in. The justification given is because the next day the stock will open up at a lower price, parallel to the amount of the dividend, which may help people who wrote uncovered calls and can now buy the stock back cheaper, but won't help the writers of spreads.
    #10     Oct 31, 2005