There are a few reason why the stock price decreases after a dividend is paid:
- The stock price automatically decreases by the dividend amount to reduce "dividend capture", which is a form of arbitrage when traders try to buy a stock days before an expected divident and try to sell it a bit later, capturing the dividend as pure profit.
- Stocks that pay dividends are making the choice to reward the stockholder with cash instead of reinvesting profits into the company to grow its business. When a pile of money gets paid to stockholders, that's a signal that the long term growth potential is decreased (compared to if it had reinvested the money), at least a little bit. A dividend payment is an outflow of cash, so the company is worth less, and so its stock should probably be priced less as well.
What's the point of paying a dividend if the stock price automatically decreases? Don't the shareholders just break even?
Companies have to do something with their profits. They beholden to their shareholders to make them money either by increasing the share value or paying dividends. So they have the choice between reinvesting their profits into the company to grow the business or just handing the profits directly to the owners of the business (the shareholders). Some companies are as big as they want to be and investing their profits into more capital offers them diminishing returns. These companies are more likely to pay dividends to their shareholders.
I assume the price of the stock "naturally" increases over the year to reflect the amount of the dividend payment. This is kind of a vague question but then doesn't it make it difficult to evaluate the fluctuations in stock price (in the way that you would a company that doesn't pay a dividend)?
It depends on the company. The price may recover the dividend drop... could take a few days to a week. And that dependings on the company's performance and the overall market performance.
With respect to options, I assume nothing special happens? So say I bought $9 call options yesterday that were in the money, all of a sudden they're just not? Is this typically priced into the option price? Is there anything else I need to know about buying options in companies that pay dividends? What if I had an in-the-money option, and all of a sudden out of nowhere a company decides to pay a dividend for the first time. Am I just screwed?
One key is that dividends are announced in advance (typically at least, if not always; not sure if it's required by law but I wouldn't be surprised). This is one reason people will sometimes exercise a call option early, because they want to get the actual stock in order to earn the dividend.
For "out of the ordinary" large cash dividends (over 10% is the guideline), stock splits, or other situations an option can be adjusted: http://www.888options.com/help/faq/splits.jsp#3 If you have an options account, they probably sent you a "Characteristics and Risks of Standardized Options" booklet. It has a section discussing this topic and the details of what kinds of situations trigger an adjustment. A regular pre-announced <10% dividend does not, while a special large dividend would, is what I roughly get from it.
That "Characteristics and Risks of Standardized Options" is worth reading by the way; it's long and complicated, but well, options are complicated.
Finally, do all companies reduce their stock price when they pay a dividend? Are they required to? I'm just shocked I've never heard of this before.
The company doesn't directly control the stock price, but I do believe this is automatic. I think the market does this automatically because if they didn't, there would be enough people trying to do dividend capture arbitrage that it would ultimately drive down the price.