Covered Calls and Dividends

How to Write Calls on Stocks That Pay Dividends

Writing covered calls on dividend paying stocks can be a little different from writing calls on stocks where earnings are all retained. Your best bet for call writing success is to understand the relationship between covered calls and dividends.

In fact, dividend distributions can impact the call selling process in two important ways.

Covered Calls and Dividends - Early Exercise

If you've written a call, one of the last things you might expect is to be assigned early. Although not as unpleasant as being assigned early when writing naked puts and being forced to purchase shares (and presumably for a lot more than what they're currently trading at), it can still be disappointing if you really didn't want to sell the shares.

When you've written a call and the call owner exercises the option early (and you get assigned), all that's really happening is that trade has been accelerated and ended early.

And in many instances - especially if you take the sensible approach of writing in the money calls to begin with - this means your trade was a success and you achieved your maximum return earlier than expected.

The only time someone is going to exercise their call option early is when that call is in the money, when the share price exceeds the strike price of their call.

But just because a call option is in the money, doesn't mean it's going be exercised early. After all, most calls are bought with no intention of ever being exercised - they're either part of some multi-leg strategy or else just purchased outright speculatively as part of a bullish leveraged bet.

Exercising a Call Early to Collect the Dividend

An exception can occur when dividends are involved.

Remember, that the only way an owner of a call can collect the dividend from the underlying stock is to exercise the call and acquire the shares before the ex-dividend date.

There are two factors that increase the likelihood of early assignment:

The size of the dividend - You're far more likely to face early assignment with high yield stocks than with a stock that only pays a marginal dividend.
The amount of remaining time premium - If the value of the dividend exceeds the time value remaining on the call, it's more likely that the call will be exercised early.

Covered Calls and Dividends - Option Pricing

One issue that rarely gets discussed when it comes to covered calls and dividends is the impact the dividend cycle has on option pricing.

In general, a call's value tends to be reduced by the amount of the dividend expected to be paid out during that option's holding period.

The easiest way to understand this is to consider life from the call buyer's perspective. Suppose you buy an at the money $40 call on a stock that is scheduled to pay a $0.50/share dividend prior to the call's expiration.

Naturally, you want the share price to rise. The higher it goes, the more your position increases in value. But wait a minute - while you're holding your long call, $0.50/share in cash just gets up off the company's balance sheet and walks right out the door. That hardly seems fair, does it?

But what does make it fair is that the dividend is factored into the pricing of the option to begin with.

You can easily see the impact dividends have on covered call option pricing on your own by checking out the option chain on both dividend paying and non dividend paying stocks.

Look at those stocks trading at an at the money strike price. All else being equal covered calls and naked puts have an identical risk-reward profile.

Of course, when dividends are involved, all things aren't equal. So for stocks that pay no dividend, the premium amount should be the same for an at the money covered call as it is for an at the money naked put.

But when a dividend is paid out during that holding period (and if the stock doesn't pay a dividend in the front month, you may need to go out two or three months to see this) the price of the call option will reflect the anticipated share price headwind and be lower by an amount that's roughly equivalent to the dividend payout.