The fifth input into the Option Pricing Model is dividends. If the underlying pays no dividend, then there is no effect on option prices. However if the stock does have an upcoming cash dividend payable, it will have an effect on option prices. It is very important to be aware of this, as many a neophyte option trader has been caught out by thinking an arbitrage opportunity existed with mis-priced options, when in fact the pricing anomaly was due to an upcoming dividend; hence not an anomaly at all.
The reason for this is that option holders are not entitled to participate in cash dividends, so option prices must compensate.
It is a general rule of thumb that the underlying stock will drop by the dividend amount when the stock goes ex-dividend, all things being equal. As far as the stockholder is concerned, he/she ends up squits; what is lost on the stock, is gained in cash.
Option Pricing Formulae account for this by considering the move in the underlying due to going ex-dividend.
When the stock is cum-dividend, call option prices will be cheaper than they would be if there were no dividend payable, reverting to “no-dividend” pricing on the ex dividend date. This has the effect of shielding the call option holder from an unwarranted loss due to the drop in the underlying.
The reverse is true for put options. When the stock is cum-dividend, put prices will be more expensive than they would be if there were no dividend payable, reverting to “no-dividend” pricing on the ex dividend date. This has the effect of ensuring that the put holder doesn’t receive an unwarranted windfall profit.
In a Nutshell
When a dividend is payable:
- Call option prices will be cheaper.
- Put option prices will be more expensive.