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How Special Dividends Can Sink Options Investors

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With the fiscal cliff looming, special dividends have never been more popular. Dozens of companies are making substantial payouts before the end of the year in order to avoid any possibility that current low rates of 15% on qualified dividends won't be available in 2013 and beyond, and in general, shares of companies declaring those dividends have risen as investors applauded the moves.

But for one specialized area of the investing world, special dividends introduce a big headache. Options investors have to check closely when an underlying stock declares a special dividend to make sure they understand the potential impact and make the right moves.

Dividends and options
Options investors are used to having to pay more attention to dividends than most investors. Typically, if you own a stock, you can just sit back and watch dividend payments come into your account. With options, though, dividends raise a question: Should you exercise an option early in order to collect a dividend?

With ordinary dividends, the answer is sometimes yes. Usually, it makes more sense to sell an option back into the market rather than exercise it early, because buyers will be willing to pay at least something for the time value that the option gives them. When a dividend is imminent, though, the time value of holding on to the option may well be less than the amount of the payout. In that case, early exercise makes sense.

Special dividends, though, are another matter entirely. That's because unlike regular dividends, special dividends actually change the terms of the options contract. For instance, consider the changes to options that these recent special dividends have led to:

  • Costco's (NASDAQ: COST  ) recent $7-per-share special dividend led to strike prices on options being adjusted downward by $7. So if you previously held a call option to buy Costco shares for $105 each, it will now allow you to buy those same shares for just $98 if you exercise.
  • CYS Investments (NYSE: CYS  ) will have its options strike prices adjusted down by the $0.52-per-share special dividend that becomes effective Dec. 19.
  • Investors in Whole Foods (NASDAQ: WFM  ) options had a $2 downward adjustment to strike prices made on Dec. 6 to account for the special dividend that investors will receive later this week.
  • In the casino gaming space, both Wynn Resorts (NASDAQ: WYNN  ) and Las Vegas Sands (NYSE: LVS  ) got special adjustments for their big dividend payouts, with Wynn seeing $7.50-per-share reductions while Sands got a $2.75-per-share reduction.

All this may sound complicated. But the gist of it boils down to this: If you bought an option, you basically get the benefit of the special dividend, because it's automatically reflected in the price of the option. On the other hand, if you were the one to write the option -- such as through a covered-call strategy -- the special dividend payment you'll receive may well be offset by the reduction in the strike price you'll receive per share if the option gets exercised.

Take a closer look
There's no hard-and-fast rule about when a dividend rises to the point at which it becomes special and therefore triggers changes in option terms. For instance, plenty of stocks have double-digit dividend yields based simply on their regular dividend payout rates, but option contract terms don't get amended every quarter when they make payouts. On the other hand, even a relatively small payout could trigger option changes if it's out of the ordinary for the stock involved.

Perhaps the biggest potential pitfall is for covered-call writers. When the strike price of the call option you've written goes down, it increases the likelihood that the option will get exercised and that your shares will get called away. Many investors want to avoid that at all costs, so if you're really concerned about that possibility, you'll want to buy back the call option you wrote to close the option position.

Options can be tricky, and special dividends make them trickier still. But as long as you're aware of the impact that special dividends have on options, you can prepare for whatever happens.

Costco's special dividend is just the latest in moves that have given long-term investors a 100-bagger since the early 1990s. But is the ride over for Costco investors? To answer that, we've compiled a premium research report with in-depth analysis on whether Costco is a buy right now, and why. Simply click here now to gain instant access to this valuable investor's resource.

Read/Post Comments (3) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 19, 2012, at 12:34 PM, jabez1 wrote:

    Are you saying that the owner of CSCO must now surrender shares $7 cheaper than the original contract?

    If so, there must be something in the fine print that I did not read.

  • Report this Comment On December 19, 2012, at 9:09 PM, DocReits wrote:

    From the article:

    ""Perhaps the biggest potential pitfall is for covered-call writers. When the strike price of the call option you've written goes down, it increases the likelihood that the option will get exercised and that your shares will get called away. Many investors want to avoid that at all costs, so if you're really concerned about that possibility, you'll want to buy back the call option you wrote to close the option position""

    To be fair, it is a difficult idea to grasp, when option strike's are adjusted down(the strike prices themselves) for special dividends, such as Costco's from say 105 to 98 and the trader exercises, for example, on the EX date or later, he does not gain or lose """"anything""", because the price of the new 98 strike is """"exactly"""" the same as the price of the 105 strike he had the previous day.

    IOW, if he had a 105Call strike he paid 2.50 for @ a PPS of 105(before the EX date) and he exercises on the DBEX, he would be long shares @ 105 and receive a 7.00 dividend holding the share into the open on the EX date.

    Now his shares are worth 98.00 and he sells, after the EX date. His net is a -2.50...(98-105 -2.50//price of call// +7.00 divi = -2.50). This is the exact place he was before the EX(-2.50).

    OTOH, the short Call trader pockets 2.42bid on those same Dec105Call strikes on the day before EX, and the next day he owns 98 strikes that are priced at.....2.42..amazing!!

    So even though he now has a 98 strike Call, and it is no longer a 105 strike Call, the PPS is no longer is 98.00 and his Call is the exact same price!!!!! Everything(the PPS and his strike) EXCEPT the price of his Call is 7.00 less.

    This is just another example of net zero arbitrage. The MM's are not going to allow gaming of the system..or else...everyone would be doing it....nor do they eat the short Call trader's lunch.


  • Report this Comment On December 20, 2012, at 8:03 AM, kickbishopbrenna wrote:

    Of Options currently in MFO recommendations, TD Ameritrade will be affected by this. i don't see any others yet.

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