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How do dividends affect call and put options? July 17 2017Effects of Dividend on Stock and Option Prices

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How do dividends affect call and put options?

Dividend per share (DPS) is the amount of dividend received by the shareholder on a per share basis. The company distributes dividend out of the profits of the company after deducting tax (PAT). The overall appeal of a company increases when it pays regular dividend, and hence attracts several buyers. If you want to diversify your portfolio profitably, dividend surely is source of a little extra income. It is observed in the BSE and NSE share market that a company with constant profits that issues dividends tends to be more trustworthy and prone to high share sales in the market. Below is a brief explanation of how stock and options are interlinked with the rate of dividend of a given company so as to help you take effective investment decisions. Let us first understand the effect of dividend on stock prices.

1.     How Dividend Affects Stock Prices

A dividend once announced can have a short term fluctuation or show long term effects on the stock prices. Trends in the stock market may change for the good or bad based on the rate of the dividend.

Dividend Rate Fluctuation

If the dividend announced is higher with respect to the expectations of speculators, the market will experience a rise in the stock price of the company. If you own such shares you can choose to sell it off at a profit, or retain it while enjoying a good dividend. Turned the other way round, if the dividend announced is lower than the expectations of speculators, the stock prices tend to go low with a display of low profitability in the current year. You will not only see your share value fall, but also earn a lower dividend. Several investors act quickly based on the slightest indications of the expected dividend before it is even announced. This adds to the volatility of the stock market.

Announcement of Ex-Dividend

On the Ex-dividend date, the price of the stock falls by the dividend amount, though it eventually moves back to its previous price in time. This is because the cash now being labelled as dividend is not a part of the company’s earnings. Generally, when a company announces its dividend, the amount of declared dividend is added to the stock price. As the company sets an ex-dividend date, any investor purchasing stock before the same is eligible for dividend payment. In case the stock is purchased on or after the ex-dividend date, the dividend will be paid to the seller of the stock.

Announcement of Special Dividend

A special dividend, also known as an extra dividend, is a one-time distribution of corporate earnings to company shareholders. It usually stems from exceptional profits during a given quarter or period, for example, the sale of an overseas branch or subsidiary. If the cash flowing in through such a transaction is exponentially huge, the company may revise the rates of the share altogether. Since you get paid for simply owning your shares, (say, Rupees 100 each) many people would like to buy in just to get the special dividend (say, Rupees 75 per share). The stock price of the shares would rise in the market due to new demand. On the ex-dividend date it would fall by Rupees 75; as the stock price gradually moves back to its previous price of Rupees 175, the rate change becomes permanent.

After understanding the effect of dividend on stock prices, let us delve into knowing the effect of dividend on stock options.

2.     Effects of Dividend On Stock Options

A Stock Option refers to a privilege, where the purchaser and seller enter into an agreement to sell the stock at a predetermined price on a given date. The purchaser has the right to buy or sell a stock, but is under no obligation to do the same. Every time a company declares dividend, the stock price is discounted by the market. This leads to a lower market price per share of the ex-dividend price. The price change that the stock goes through due to ex-dividend also has an impact on the price of options, namely Call and Put.

Call option

A Call refers to when a purchaser enters into contract to buy stock on a certain date for a certain consideration. The decline of the stock price on the ex-dividend date results in a decline in the value of call options. The declaration of dividend observes a decrease in the premium of the call option.

Put option

A Put refers to when a seller makes a contract to sell his stock on a certain date for a certain amount. When the prices of the stock drop due to dividend declaration, the value of put option always rises. This is because the stock price reduces by the amount of dividend to be distributed. This effect is the reverse of what would happen to a call option.

 

Bottom-line

The smart way to invest in stock markets would be to keep an eye on companies with consistent profits and returns to the shareholders. A strong company always gives back to its members. Hence the biggest signs of a company worth investing in lies in their returns. One should be cautious enough to verify in case of high dividends, that the company actually earns profits high enough or is deceptively trying to hook immature investors. Even though dividends are not the only criteria to investing and trading, knowing how dividend income can boost your profits is essential.

At Indira Securities, we help you make the right trading and investing decisions through our blogs written specially for stock market enthusiasts.

Happy trading!

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