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Minyan Mailbag - MSFT


position in msft


Note: I have received a number of inquiries regarding my previous analysis of Microsoft (MSFT:NASD) and the "special one-time" dividend. I'd like to share some thoughts as I think it provides an excellent real-time educational example. Minyanville does not provide stock-specific recommendations and this is simply offered to analyze the thought process involved.

A lot of Minyans have asked about the benefits of setting up a buy-write in Microsoft (ie-buying MSFT and selling the January 25 calls) as there is a widely perceived assumption that one can capture the dividend both ways. As one Minyan put it, "you get the premium ($3.40 on the 25's) and the $3 dividends in Dec, total $6.40. If you're taken out at $25 you are left with a $3.8 profit (14%) and it is fairly safe."

Let me explain how this trade in MSFT to "capture" the dividend is deceiving.

First you pay $27.60 for MSFT stock and sell the MSFT January 25 call at $3.40; the time premium (which is the call price over intrinsic value and is essentially what you "profit" from) is $.80. So you say as long as the stock price is above the strike by expiration you will "earn" this time premium of $.80 plus the dividend of $3 paid sometime in the fourth quarter. I agree with the $.80 but not the $3. Here is the problem.

The strike price of 25 (and those of all MSFT options for that matter) will be adjusted downward by $3 on the ex-dividend date: the 25 strike call will become a 22 strike call instead. When the person long the call eventually exercises, you essentially must deliver them the stock at $22 not $25. So even though you receive the $3 dividend, you lose $3 in "exercise price".

This makes your net profit only $.80 instead of the $3.80 that you were assuming.

There is also a possibility that the buyer of this call option exercises early to get the dividend (this depends on where the stock is at the time and what the "put is worth". In this case you will not receive the dividend but receive $25 instead of the $22 since the strike is not adjusted until after the ex-dividend. In that case your net profit would also be $.80 in time premium (the call price $3.40 you get from selling the call plus the $25 you get from assignment minus the $27.60 you paid for your stock).

And remember, you won't necessarily get exercised: the stock could drop below the strike; you bear all the exposure to MSFT below $22 (post dividend where the stock is $3 lower in price). You must be willing to be long the stock below $25 pre-dividend or below $22 post dividend in order to do this trade.

Regardless, your only profit would be $.80. Again, this isn't offered as advice---there's a lot of confusion and I wanted to use it as an educational opportunity.

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No positions in stocks mentioned.

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