Short calls options and dividend payout (part 2 of 2)

In my previous article, I talked about the impact of dividends for holders of (deep) in the money calls. The bottom line: as an owner of an in the money call of a stock that is going to pay out dividend, it is wise to see if the call option is going to lose value because of the dividend payment. If so, then it is advisable to sell or exercise the call before the dividend payout. 

But how does it work if you have an in-the-money call short option and dividend payout is coming up? 

The situation 

It is Monday and ABC stock is quoted at EUR 25. On Wednesday, the stock goes to EUR 1 ex-dividend. Earlier, you sold an uncovered call option on the stock with a strike price of EUR 20 and the maturity is in three months. You don’t own any shares. 

The price shown on the screen for this call option is EUR 4.95 bid and EUR 5.05 ask price.  Thus, the call option consists entirely of intrinsic value. The put option, with the same maturity and strike price of 20, quotes EUR 0.35 - EUR 0.45. 

Assignment 

By writing the call, you have entered into a (potential) obligation to deliver the share, and there is a 99.9% chance that you are going to be held to that obligation before the ex-dividend date. The reason behind this is explained in the first article. In other words, you are designated (assigned) to deliver. 

In the case of upcoming dividend payout, there’s two possible scenarios: 

Scenario 1: If your call was bought by another private investor, they might decide to exercise it as early as Monday. Tuesday morning you will receive a notification about this assignment. Effectively this means that on Tuesday morning, you start with a short position of 100 ABC shares (per option). These 100 shares will automatically be bought by Saxo Bank at the Tuesday opening. Not nice, but there is nothing to worry about the upcoming dividend because you no longer have a position. The dividend payment is not going to affect you. 

Scenario 2: In this scenario the call option is exercised by the holder on Tuesday at the end of day. This means that the counterparty (which is most likely a market maker) has become beneficial owner of the shares going ex-dividend tomorrow. In short, the counterparty is entitled to the dividend. 

Then, on Wednesday morning, you will see that you are short 100 shares of ABC. These are again bought by Saxo Bank at the opening so that delivery can be made to the counterparty. The best estimate for the price at which this happens is EUR 24 (closing price Tuesday was EUR 25 minus EUR 1 dividend). 

But, in this case, you are also short the dividend. This means that you have to pay the gross dividend of EUR 1 to the counterparty. Of course, this makes sense because otherwise you would have earned EUR 1 (times 100 per short option contract). You were committed to delivering the shares at EUR 20 while the stock is trading at EUR 25. This means that this would "cost" EUR 5. (For simplification, I’ve left out the received option premium in this example). 

If you could buy the shares the next day for EUR 24, it would only 'cost' EUR 4. Then you would have 'earned' EUR 1. So, this math does not work out because you must pay the EUR 1 dividend to the counterparty. 

What about (deep) in-the-money call spreads? 

This is a position that is a bit more complicated because it involves a long call option and a short call option, both of which can be exercised early. There is a 99.9% chance that you will be assigned in the short call and then what I have written in this article applies. But for the long call, you must act yourself (see also the other article). 

The solution to "the deep in the money call spread problem" can be solved in two ways. The first, and simplest, solution is to close the spread in its entirety before the dividend payment. The second solution is to assume that you will be assigned in the short call (probability 99.9%) and as a countermeasure you exercise your right to buy to meet the delivery obligation. These two scenarios are detailed below. 

Call spread example 

It is Monday and ABC stock is quoted at EUR 25. Wednesday the stock goes EUR 1 ex-dividend. 

Long C ABC with strike price EUR 15:  EUR 9.95 - EUR 10.05 put = EUR 0.05 - EUR 0.10 
Short C ABC with strike price EUR 20:  EUR 4.95 - EUR 5.05 put = EUR 0.35 - EUR 0.45 

Solution 1: Close the spread before the fund goes ex-dividend. You do this on Monday or Tuesday. The maximum value is EUR 5, and you will probably be able to close the spread at EUR 4.95. 

Solution 2: Exercise your long call position with a strike price EUR 15 before the ex-date, as you assume, you will be assigned for the short 20 call. Exercising the long call position (with a strike price of EUR 15) yourself before the ex-date will give you the shares, including the dividend, in time to meet your delivery obligation. 

What if you don't take any action? 

Then the probability is 99.9% that you will lose money. What happens to the short position with a strike price of EUR 20 is clear; it will be exercised by the buyer, and you must deliver the shares (including the dividend). Your long position, with a strike price of EUR 15, on the other hand, has an intrinsic value of EUR 10 today, but on Wednesday the call will only be worth EUR 9 intrinsically (plus interest plus the put premium). On Wednesday, the long position with a strike price of EUR 15 - at an expected opening of EUR 24 - will quote around EUR 9.20. This means a loss of EUR 0.80 per spread. 

What you should remember 

If you are short an in-the-money call option before a dividend payout, chances are extremely high that you will be assigned to deliver. Realize that you will then also be short the dividend and that will also have to be settled. This may feel unfair but, as explained in the example above, it is the right way.  

In short, with a long in the money call spread, it is important that you act because otherwise the dividend will have a negative impact on your P/L.