Dollars & Sense December 27, 2001

Go Back to Archives	"Dollars & Sense" By Tom Haugh - Chief Investment Officer

Dividends and Options Strategy December 27, 2001

In previous articles we have talked about whether corporations should pay dividends and when shareholders should expect management to "share the wealth". We have also talked about how the payment of dividends is structured, the key dates involved, and the effect of the dividend on stock pricing. The next topics are the effects of dividends and dividend surprises on the pricing and early exercise of stock options. This is especially important for those investors who are beginning to invest in foreign companies or ADR's, where sometimes the custom is one large dividend paid annually.

The effect of a regular dividend on a well-defined payment schedule is rather easy to assess in an option pricing model. Keep in mind that we are talking about past regular dividend payments being a predictor of future action. The company itself is only obliged to pay a dividend already declared, and every declaration is an independent event. The company declaring a quarterly dividend 200 quarters in a row is just that, history, and does not obligate the company to declare a dividend in quarter 201. Also, and sometimes equally important, the date on which the stock becomes ex-dividend historically may change slightly, causing it to fall unexpectedly on a different side of the monthly option expiration than predicted.

The simple addition or change in predicted dividend patterns can be easily handled by any option pricing model. To illustrate, I have used the stock eBay Inc. (EBAY) for the purposes of example. Let us assume, without laughing too hard, that the eBay Board of Directors decides to declare a quarterly dividend of $.40 starting on 2/12/02. How will the "drag" on the stock price caused by the actual payment of cash affect the option pricing going forward? The following table represents a sample of theoretical Call prices with the only variable changing being the addition of the dividend stream. The stock price is $66.45 on 12/27/01 with a predicted volatility of 60.

Option	Theoretical Value Without Dividend	Theoretical Value With Dividend
JAN 65 Call	$4.83	$4.83
FEB 65 Call	$6.87	$6.81
APR 65 Call	$10.01	$9.75
JUL 65 Call	$13.31	$12.73
JAN 70 (03) Call	$16.28	$15.44
JAN 70 (04) Call	$23.50	$21.99

As we would expect the drag on the predicted stock appreciation caused by the dividends is reflected in lower theoretical call values going forward, with the biggest effect on the long-term options. It would certainly make sense that an investor would be less likely to want to hold long-term options in a stock paying a substantial dividend, as the stockholder receives the dividend and the option holder does not. In fact, one of the risks of holding long-term options is a surprise dividend announcement by the company, as the price of those options should fall as in the above table. Of special concern is any sort of major "special" dividend that may be declared, more likely to happen with foreign companies, but still possible with domestic companies. Next week we will cover when it may be necessary to exercise your call options early to "capture" the dividend.

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