Options 101: Dividend Risk Explained
Writing covered calls means you may not collect dividend.
If you own stock and want to collect the dividend, and if you also want to write covered calls that are slightly in the money, then you may encounter dividend risk.
When the stock rallies before the stock goes ex-dividend, sometimes that dividend is large enough to encourage the call owner to exercise the option one day before the stock goes ex-dividend. When that happens, you're obligated to sell your stock, and thus, fail to collect the dividend.
Not all options are exercised for the dividend. Obviously, the option must be a call and not a put, and must be in the money - or there's no chance it will be exercised (barring a very unusual mistake by the option owner). But being ITM is not sufficient reason to exercise. Why?
The exerciser now owns stock instead of calls. Thus, the proud owner of the stock and its dividend, now has downside risk. That's the risk of losing money if the stock declines below the strike price of the call (which no longer exists). When that happens, the exerciser loses more money (when owning stock) than he/she would have lost owning the call. That possibility makes the decision to collect the dividend a difficult choice.
The careful call owner only exercises when 2 things are true: the stock has zero time value and the delta is 100.
For readers who are less experienced in the finer points of options, here's an easier way to understand the explanation: The perceived risk that the stock will dip below the strike price must be low enough for the call owner to take that chance - in return for the dividend. In practical terms, this often means the corresponding put (same strike and expiration date as the call) can be bought for less than the dividend; and the cost to own the stock from exercise date through expiration (interest not earned on the cash used to pay for the shares) is less than the dividend.
If you have a copy of the Rookie's Guide to Options, there's a thorough discussion on pages 92-93.
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