Beginner options traders sometimes forget two factors

Today we are discussing two topics that novice options traders may not be familiar with.

The first is the impact of dividends.

If the underlying stock doesn’t pay any dividends, then the trade is pretty straightforward. For example, if you buy a call option on XYZ stock with a strike price of $ 50 and the stock is trading at $ 45, then the stock is $ 5 off the money.

But let’s say the same stock pays a dividend of $ 0.50 each quarter and there is an ex-dividend date between when you buy the call option and the option expires, then you are actually $ 5.50 cash ($ 5 + $ 0.50) at the time of purchase.

On the ex-dividend date, the share price will be adjusted downward by $ 0.50. Thus, the stock price will have to compensate for this additional $ 0.50 before reaching the strike price of $ 50. This is what I mean by the effective distance being $ 5.50.

Note that the key is the ex-dividend date, not the actual payment date. The ex-dividend date is when the share price adjusts downward in the amount of the dividend. If you buy an option after the ex-dividend date but before the payment date, the payment of that dividend will not affect the stock price since the price has already been adjusted.

Baked dividend in the premium

If you buy a put option instead, a dividend helps you in that it reduces the distance between you and the money. So if you bought a $ 40 put on XYZ (again, trading at $ 45), the put is actually $ 4.50 to the money at the time of the purchase. because in the future, the dividend will lower the share price by $ 0.50.

If you were the option seller instead of the buyer, the dividend will help you as the buy seller and hurt you as the sell seller. (Unlike when you’re long with the options.)

The market is not stupid. Therefore, the expected value of the future dividend (s) is implicitly included in the option premium. Thus, all other things being equal, the adjustment of the expected dividend increases the premium for a put and decreases it for a call. You should take this into account when considering which option to buy.

If you ever notice a premium spread between a put and a call on the same stock, the dividend is probably the reason. Don’t assume the call is “cheaper” than the put just because the premium is lower.

When an action divides

Next, we look at a rarer event, which happens to options when the underlying stock is subject to a stock split or reverse split.

First, let’s take a look at what happens when a stock splits. For example, if you had 100 shares of XYZ valued at $ 50 each, after a 2-to-1 split, you would have 200 shares at a price of $ 25 each. The total value of your XYZ position remains unchanged at $ 5,000. In a reverse 1 to 2 split, you will end up with 50 stocks worth $ 100 each. Again, the total value remains at $ 5,000.

The good news for options traders is that in the event of a stock split or a stock split, their option positions will automatically be adjusted so that their exposure to the underlying stock remains the same.

Sometimes when a high priced stock divides, the lower value (note: not cheaper) might attract additional buying interest. But other than that, it doesn’t affect the pricing of the option much.

If you were a buyer on a purchase contract with a strike price of $ 50, after the automatic adjustment for a 2-for-1 split, you would end up with two contracts, each with a strike price of $ 25. . Prior to the split, the call option gave you the right to buy 100 shares of XYZ at $ 50 per share, for a total of $ 5,000. After the split, the options give you the right to buy 200 shares of XYZ at $ 25 per share, also for a total of $ 5,000.

Normally, an option contract is for 100 shares. In the case of a 1 to 2 split, however, each option contract will only cover 50 shares and the strike price will double. Continuing with the example above, this means that the strike price will double to $ 100. So the total value of XYZ that the option gives you the right to buy is always $ 5,000.

Options trading can be quite lucrative, but as my article just showed, it can also be complex. One of the smartest options traders I know is my colleague Jim Fink. Are you looking for rapid growth, with less risk? Consider enlisting Jim’s expertise. He has a way of making everything look simple.

As chief investment strategist of the premium trading service Speed ​​traderJim Fink has pioneered options investing methodologies that make money in bullish and bearish markets, in good times and in bad times.

Jim has put together a presentation that shows savvy investors how to make massive gains in a short period of time. Jim will guide you through his trades, step by step. Click here for free access.

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