There is an interesting theoretical argument to be made (here is my pipe, take a puff). If you assume that the company is accruing cash for the dividend over the duration of the dividend period, the stock should be rising gradually and then dropping back by the dividend amount. Assume your spot is $100 and div is $1 - in a regular model, forward on the ex-div date will be $99 while in our "guaranteed dividends" model it's still $100, but it will be $101 the day prior to ex-date. If this is really true, puts priced in a regular model would be statistically overpriced - the fwd mis-pricing will be negligible if you delta hedge with stock, obviously. There, now you can exhale - help yourself to some curry once the munchies start
We (the market) are subtracting the dividend from the spot... Options pricing is based on the forward price of the spot. If a dividend is involved, that forward price is spot-dividend... and +interest to be exact. Because the dividend lowers the spot, the puts are usually always priced on spot-dividend and are not exercised early... at least not before dividends. Unless interest over the strike price is higher than the dividend... I can go on with more theoretical stuff but no time.. Uhm, calls can be exercised early when the dividend is large enough and you want to capture it. By exercising the call, you give up any other benefits to holding the call (basically any time value if kept, which is the value of the put ). So you do not exercise the call when the value of the put is higher than the dividend... (I cut a few corners here, but otherwise I think it will too complicated). Ponder on this for a few days and let me know if you grasp it... JR
But, that up move should already be in the current price... that's just discounted future earnings isn't it? That's also one of the reasons I'm not so massively keen on dividend stocks... dividend is just connected (or so it should be) to earnings. And I would rather buy stocks with higher earnings that keep that cash in the war chest for future development/takeover etc. Anyway, dinner time for me... cheers
Quick question while iam pondering over this, what model of pricing are you implying or using here in the calculations?
Ha! In the risk neutral world there is no connection to CAPM, so it's not clear if it would be in the current price. Cash in a bank, however, is definitely accounted for in the current price (judging by how perfectly bank stocks react to the changes in large reg fines, for example). So there is something to be said about this theory having merit, if you smoke enough happy cabbage. PS. In general, treatment of dividends is really strange in the risk neutral world. What happens to the stock if it keeps paying high divs and yet keeps going down, does it go to zero earlier? what happens to the stock vol when it pays a large div, does the vol go up proportionately and does the model assume that? Wouldn't it make sense that non-div stocks have to have lower vol (since they got all that non-volatile cash sitting in their coffers)?
Because we know the stock's direction after the dividend day. It is going to drop thus I sell the vertical call spread. Some stocks recover, most don't. Running back up even higher than pre-dividend is rare, thus we have an edge. I will test it this week... I want the dividend to be at least 50 cents, and good option strikes for the stock.
A couple follow-up questions, incase I have missed something: 1) You are expecting a price action of a security around Ex-Dividend time that you are trying to profit from, correct? 2) Your references to options is merely a tool for exploiting or leveraging the price change (referenced in 1 above) you hope to exploit, correct? 3) The trade is short term (1-6 days) correct? --- If all 3 answers are YES, I can post a ThinkScript study that makes easy work of evaluating selected securities for an edge based on historical data.
How do you know the stock is going to drop? Just because it trades ex-dividend? The fact is, spot at 100, when it has a dividend of 5... ex-div it should trade at 95. If it trades at 96, it's up 1.05% if it's at 94 it's down 1.05%.... So... how come you know the stock is dropping past the dividend amount? If anything, I could argue for the upward move after dividend. There might be some selling pressure before ex-div date, because of taxation issues for shareholders. After the dividend, they might buy back... But, that's all very hypothetical.