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Options and Dividends

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With dividends the talk of the town, I want to use the heavy volume in RJR options Friday to illustrate the effect dividends have on option prices. Most traders who use mostly short term options do not even notice this effect, but they are still relevant and become crucial when trading longer term options.

RJR still pays a quarterly dividend of $.95, so the stock yields slightly over 11% a year. Because of the company's cash flow problems, it has been rumored that it will have to cut this dividend. Traders have become increasingly convinced that this is the case, and on Friday there was heavy option activity as some traders executed trades to take advantage of this distinct possibility. Essentially, they sold in the money puts and hedged the delta by selling stock short.

The biggest trade of the day was a delta neutral trade of selling 1500 January 40 puts of 2006 at $16.05 and selling 69,000 shares at $32 (the delta of the puts is .46). Notice that the hedge of selling puts is to sell stock at a percentage equal to the delta. This tells us that the trader who takes the other side of the trade (in this case me) will be long stock (and long the puts). Now if a trader is long stock and expecting a dividend and the dividend is cut, that is a bad thing. In this case, there are ten dividends of $.95 scheduled to be paid over the life of the options, so if RJR cuts their dividend it is a very bad thing for a holder of stock (in reality, cutting the dividend may or may not really be a bad thing for a stockholder, but this is an old argument and I will use this exercise to discuss it at another time).

The trader who buys the puts and stock neutral is expecting $9.11 in value (the present value of $9.50 discounted back at 3% over 10 quarters) to be paid in dividends. This value represents a significant portion of the price the trader is paying for the puts. With the full value of dividends included, the $16.05 price paid for the puts equates to a 40% implied volatility. The theoretical price (by plugging a zero dividend into the Black-Scholes model) of the puts would drop by about $4.00 to $12.05 if we assume that the dividend is cut to zero. Another, more intuitive way to look at it is since I am long 69,000 shares against the puts and I lose $9.11 in value on those shares I lose 69,000 x $9.11 = $628,000; $628,000 divided by 1500 puts equals around $4.10 in price on the puts. A quick calculation reveals that the puts will decrease in value by the present value of the dividend cut times the delta of the puts.

Dividends have a significant effect on the price of options: increases in dividends decrease the value of calls (the hedge is short stock and higher dividends means a higher payout) and increase the value of puts. The more dividends involved, the more the effect.

So did I make a mistake in buying these puts? If they cut the dividend I will certainly lose a lot of value in these puts that I bought, but I will gain more value in the puts that I had already sold anticipating this situation. I used this trade to lock in the significant value marked but unrealized in my current position.


Position in RJR

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