Buying puts before dividends get paid out

Question

This question is a direct extension of this question, which asks if you short a stock before the dividend pays out are you guaranteed money since the price should go down? The answer states shorting a stock before dividends are paid would make you liable to pay the dividend to the original owner of the stock. So if you instead bought a put before the ex-dividend date could you circumvent this?

Sidenote: I wanted to just comment on the original answer to ask this question but needed 50 reputation, so I tried to chat but needed 20 reputation, so tried to ask a question in the meta of what I was supposed to do but also needed reputation for that. I have no idea if this is the proper way to ask a question which is a simple extension of another question.

Answer 1

Post some replies to other questions and you'll have a 50 reputation in no time. Or make the check payable to me for overnight service ;->)

Here's part of my answer from the link: "There are no free lunches and if it sounds too good to be true, it is." I suppose you want something of greater substance than that, eh?

If there is a pending ex-div date, option premiums reflect it. As D Stanley stated, it's baked in. The puts will increase in value and the calls will decrease in value. For at-the-money options, the dividend is about evenly spread across both options. IOW, if the div was 50 cents, you would expect the ATM put to increase by 25 cents and the ATM call would decrease by 25 cents. For the same pair of options, the further ITM the stock gets on one side, the more the dividend distribution shifts toward the ITM option.

The reason that this is important is that if one is unaware of the pending ex-div date, one may conclude that they are getting an inflated put premium (more profit potential) along with more % downside protection than you really are receiving.

For example, if XYZ is $50 and it goes ex-div by 50 cents in the morning, receiving 75 cents today for selling the short put means that tomorrow morning your short put position opens 50 cents ITM at $49.50. That 75 cents of time premium today was effectively 25 cents of time premium and 50 cents of intrinsic value. Conversely, the put buyer is effectively buying $49.50 stock with share price at $50.00 so he must pay up by a chunk of that 50 cent discount.

You can see this easily with an option pricing model.

Answer 2

Here's an example from today that demonstrates my previous explanation about the relationship of put and call premium to a dividend.

CE closed at $113.98 today. The August $110 call closed at $4.40 x $4.90 and the Aug $110 put closed at $0.90 x $1.10 . The spreads are pretty wide and fair value is somewhere in the middle. I'm going to take the liberty of assuming that it's $4.58 for the call and $1.00 for the put. CE goes ex-dividend in two days for $0.54

The covered call writer collects the dividend and his potential profit is $1.14 ($110 + $4.58 -$113.98 +$0.54)

The writer of the short put receives $1.00 and assuming that he's receiving fair market interest for his cash (he didn't buy the stock), he receives about 14 cents of interest for a grand total of $1.14 which is the same as what the covered call writer received.

The uninformed put seller unaware of the pending dividend might look at this comparison (without including the dividend) and conclude that the put is fat and overvalued when indeed, it is not.

A reasonable objection to my option premium assumption might be that I'm simply making up what the fair value of the options is and I'm fabricating a correct answer based on that. In reality, option prices are linked by a formula for buying the stock called a Conversion (a Reverse Conversion or Reversal involves shorting the stock).

The Conversion involves buying the stock, selling a call, buying a put, and receiving the dividend (where both options are of the same series). The formula is:

+Call - Stock + Strike Price - Put + Dividend - Carry Cost = 0

If the options are fairly priced, the Conversion's profit is zero. Using all of the information from the above comparison of the covered call and the short put, including the assumed prices, it is indeed so.

This arbitrage also serves to provide liquidity to the market. If there is someone trying to sell the Aug $110 put another person trying to buy the Aug $110 call, if a floor trader or market maker can do a Conversion for a profit, he will take the opposite side of each of these two traders and offset his risk with a combination with the stock. Other than Pin Risk, it's riskless.

For a really over simplified explanation, if we pretend that the stock is at the strike price and there is no carry cost, then the formula simplifies to:

Call + Dividend = Put

IOW, the put's premium will always be greater than the call premium by the amount of the dividend.

Answer 3

The price you pay for the put will have have the expected dividend and drop in share price baked in, so the only way you'll profit is if the company pays a higher dividend than expected.

Answer 4

In the process of writing a book, I wanted to understand if people understand ex-div. In a quick google search I found this and I felt that I would be helpful and chime in.

I think that the easiest way to understand the answer might be by illustrating where your error in logic comes from and how you are looking at it incorrectly.

You think that the trader is determining the price of the option based on the current stock price. This is incorrect. For the professional option trader, the underlying price is different/modified for each month based on interest rate and dividends payable. If a $50 stock has 3 upcoming one dollar dividends this year, and for ease of convenience interest rates are zero, were you to ask me for a one year option price, I am making that price based on a $47 underlying (the current/instantaneous expected price of the stock a year from now).

This is why some say that the dividends are 'baked in.' This is why the above example makes it look like the puts and calls at the same strike are unbalanced. It's because you are looking at extrinsic and intrinsic based on the wrong price of the underlying.

FYI, my option trade volume is in the billions of contracts and the best advice I can offer is what I tell my friends: Keep the heck away from options.