Dividends and options

[John H]

Could someone please tell me if the following statement is correct?

1) The holder of a call option will not receive any dividends on the underlying asset between the time the option is bought and the time it expires as the dividends are paid to the holder of the underlying asset.

2) The holder of a put option will receive any dividends on the underlying asset between the time it is bought and expiry as they are holding the underlying asset during this period.

If these statements are correct, as the rate of dividend increase the option price will fall for a call option and rise for a put option.

The reason for my question is that I have looked through the Sepetember 2003 exam paper and question 5(iii) asks what causes the price of a put option to increase. The answer states - if dividends reduce. which contradicts the 2nd statement above.

 

[didster]

Options by themselves (either put or call) do not pay you dividends.
You need to hold the underlying asset for dividends.

I don't think that effects of dividends on stock prices is clear cut (depending on the market's view, lower dividends could raise/lower stock prices, I think). The value of the option is purely in relation to the stock price.
Maybe someone else can answer this one.

 

[John H]

So to confirm:

The holder of a call option does not hold the underlying asset from time t to T, so does not receive any dividends throughout this period.

The holder of a put option holds the underlying asset from time t to T so will receive the dividend income during this period.

So an increase in rate of dividend income will increase the value of put option and reduce the value of a call option.

Is this correct?

 

[didster]

The owner of a put/call can hold the underlying as an additional asset.
If they hold the underlying they get the dividends.

Owners of a put don't have to hold the underlying, but may do so to hedge losses when the option comes up for payment.

Think of options as a side bet on shares. If you bet on horses and they do well, you get paid (like the option). If you happen to own one of the horses that did well, you'll get the prize money (like the dividend). Note you don't need to own the horse to bet. It's the same with share options.

I think the examiner's train of thought is that a drop in diviends would reduce the value of the share at expiry, increasing the profit to be made on the put option, so the option's current price will increase.
If you had a call then the opposite will hold, lower share price means lower option payoff, lower current option price.

However, I'm not sure what the reasoning is for saying that the lower dividends reduces share price. It really depends on the market's perception.

 

[jensen]

So to confirm:

The holder of a call option does not hold the underlying asset from time t to T, so does not receive any dividends throughout this period.

The holder of a put option holds the underlying asset from time t to T so will receive the dividend income during this period.

So an increase in rate of dividend income will increase the value of put option and reduce the value of a call option.

Is this correct?

Hi John

Don't mean to confuse you, but I feel that is incorrect.

When a share pays dividend, the holder of the call (who wants to buy the share) can enjoy the benefits of the dividend if he exercises the option. Therefore price of call increases with dividend.

For a put option, the holder (most likely) is holding the underlying share. If the share pays dividend, the holder is enjoying the dividend, and not the potential buyer for the share (the counterpart does not own the share, yet). So the price of the put reduces to compensate this.

Another way to look at this is the put-call parity relationship. You will see that if dividends are increased, the price of the put option will reduce.

Does this make sense?

 

[mattt78]

dividends

my understanding was that increased dividends decreases the value of a call option and increased the value of a put option. Is that not correct?

I thought the logic was something along the lines of that the call option holder misses out on the dividends, whereas as the call option holder (assuming they hold the underlying security they've promised to sell) will receive the dividends.

 

[tatebiti]

i agree with didster the value of a put =max(K-S,0).u dont necessarily have to own the underlying share.but the share price is equal to the present value of all future dividends .so a fall in dividends implies a fall in S and an increase in K-S..etc

Could someone please tell me if the following statement is correct?

1) The holder of a call option will not receive any dividends on the underlying asset between the time the option is bought and the time it expires as the dividends are paid to the holder of the underlying asset.

2) The holder of a put option will receive any dividends on the underlying asset between the time it is bought and expiry as they are holding the underlying asset during this period.

If these statements are correct, as the rate of dividend increase the option price will fall for a call option and rise for a put option.

The reason for my question is that I have looked through the Sepetember 2003 exam paper and question 5(iii) asks what causes the price of a put option to increase. The answer states - if dividends reduce. which contradicts the 2nd statement above.

 

[mattt78]

dividends and lambda

well lambda is the change in the price of the option with respect to the dividends, and the notes say lamda for a call option is negative, and for a put option is positive

so when dividends go up in value, the call option goes down in value, and the put option goes up in value

exactly why that is, i'm not entirely sure though

are dividends before the exercise date being increased, or after, or both?

 

[geoff97531]

well lambda is the change in the price of the option with respect to the dividends, and the notes say lamda for a call option is negative, and for a put option is positive

so when dividends go up in value, the call option goes down in value, and the put option goes up in value

exactly why that is, i'm not entirely sure though

are dividends before the exercise date being increased, or after, or both?

When you pay a dividend to shareholders, the share price will drop in an instant by the value of that dividend.

So, pay more of a dividend, share price will go down more.

Remember if you own a call option, you want the share price to increase loads and for a put, you want it to fall loads.

So, paying more dividends increases the value of puts and decreases the value of calls.

I've read that back and not sure it's very clear but there's a small chance it may help!

 

[didster]

This question and answer are far from clear, and without the specifics we are more or less arguing that possibilities are certainties.

When a dividend is "paid" there are two effects:

• share value immediately drops by amount of dividend (actually occurs at ex-divided date)
• the market uses the new information to revise its views on the value of the future dividends/share value (can be said to occur at announcement date of dividend, but even so the dividend may have already been anticipated)

The latter could have various effects. For example, if market believes the reduced dividends are simply the company retaining more for higher growth in future, shares may go up. If reduced dividends suggest that all future dividends may be smaller, the share price will fall.

It's anyone's guess as to what the latter effect is and what the combined effect of the two effects above is on share prices.

Specific to this question:
I just had a look at the original question Sep 03 109 Q5(iii) which says
State the factors that might cause the time value to increase with no change in intrinsic value

A key bit of information here is that the intrinsic value is the same, ie current share value is the same.

I believe they are talking about past dividends here, ie option price change on paying dividends.

Say the share price is 1.10 and we are about to pay a dividend.
Say market expects that dividend will be 10p, and all goes as expected, the price will drop to 1.00.
If dividend instead is 0.05 we would expect the price to drop to 1.05, but price is actually 1.00 since the intrinsic value is unchanged. So the market has reduced its current value of the share (plus dividend just paid) and by extension the future expected value of the share is lower.
Total put value goes up, so time value goes up since intrinsic value is the same.

I'm fairly confident that the above is correct, but not completely so I welcome any counter arguments.