If you are doing regular covered call / share renting / buy write strategy then sooner or later you will meet the condition that the stock that being optioned is giving shareholder some dividend. And there are some interesting interaction or behavior that you need to realize during this period. Knowing this little detail will help you adjust your strategy to maximize your profit.

Out-of-The-Money vs In-The-Money Covered Call

There are 2 main type of covered call that you can do: out-of-money covered call (most popular) and in-the-money covered call, which mainly determined by your view or believe what the price of stock is going to be at the end of option period.
For example: a stock is now trading at $10 and option writer buy the option at that price to do covered call. Let say 1 month covered call for $10.5 strike price will give you 50 cents premium and 1 month covered call for $9.5 strike price will give you $1.0 permium per share (the additional $0.5 is the intrinsic value of the option – the actual premium(time value)/profit will be roughly the same – in this example 50c – in reality there could be some differences depending on the market). Then:

• If at the end of option period the stock go up to $11, both $9.5 and $10.5 option will be exercised. But there will be additional 50c profit of capital gain for $10.5 option writer (from buying at $10 and selling at $10.5) . See comparison table below:
  

  Price is $11 at option expiry date
  	Price per stock
  	$9.5 strike price	$10.5 strike price
  Stock Buy Price	$10.00	$10.00
  Premium
  intrinsic value	$0.50	–
  time value	$0.50	$0.50
  Option excercised?	Yes	Yes
  Selling Price/ Excercise Price	$9.50	$10.50
  Capital Gain
  Sell:	$9.50	$10.50
  Buy:	$10.00	$10.00
  Net:	-$0.50	$0.50
  Total Premium	$1.00	$0.50
  Total Profit	$0.50	$1.00

• But if at the end of option period the stock go down to $9, both option will not be exercised, but $10.5 option writer will suffer (unrealized) loss of 50c ($1 capital loss: buy $10,  current value $9, minus 50c premium received) while the $9.5 option writer have not suffered any loss ($1 capital loss: buy $10, current value $9) minus $1 total premium. See comparison table below:
  

  Price is $9 at option expiry date
  	Price per stock
  	$9.5 strike price	$10.5 strike price
  Stock Buy Price	$10.00	$10.00
  Premium
  intrinsic value	$0.50	–
  time value	$0.50	$0.50
  Option excercised?	No	No
  Present Value	$9.00	$9.00
  Capital Gain
  Present Value:	$9.00	$9.00
  Buy:	$10.00	$10.00
  Net:	-$1.00	-$1.00
  Total Premium	$1.00	$0.50
  Total Profit	$0.00	-$0.50

Hence, in the bearish climate -or- if you believe the stock will be heading down, in -the-money covered call would be better choice as it will give more downside protection.

Covered Call and Dividend

Now what happen if during your covered call period the company is distributing dividend? As you know, the price of the stock *usually* go down on ex-dividend date to self adjust the value of dividend that being taken from the market and only if you buy a stock before the ex-date you are entitled of the dividend, hence:

If the call option is “in-the-money”

Whether or not the option is exercised- 1 day before ex-date – is determined by dividend value and the rest of time value of the option.

• So, firstly check the time value of that option (check the premium for that particular option on the market and subtract it by intrinsic value)

Example 1

For example: let say we have:

• call option with $9.5 strike price
• Current price is $10
• the dividend will be 10cents
• the option price is now 80c (say, time value 30cents + 50c intrinsic value = 80 cents) with 2 weeks to go
• Hence, ex-date price is likely about $9.9 ($10 – 10 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital gain: 40c  ($9.9 expected market value on ex date, minus $9.5 strike price)
• Dividend: 10c
• Total profit: 50c minus the buying price of option

If he/she just sell^(*) the option, profit will be 80c minus the buying price of the option.

Hence, it is unlikely that the option will be exercise since the option holder will be profitable to just sell the option back to market.

Example 2

For example: the same as Example 1 above, except:

• the dividend will be 70cents
• the option price is now 60c (say, time value 10cents + 50c intrinsic value = 60 cents) with 1 weeks to go
• Ex-date price is likely about $9.3 ($10 minus 70 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital profit: -20c  ($9.3 expected market value on ex date, minus $9.5 strike price)
• Dividend: 70c
• Total profit: 50c minus the buying price of option

If he/she just sell^(*) the option, profit will be 60c minus the buying price of the option.

Hence, it is unlikely that the option will be exercise since the option holder will be profitable to just sell the option back to market.

But as we can see, the difference between exercising and not exercising is now quite close with the diminishing of the time value of the option. If the time value is quite trivial, then there will be very little difference between exercising or not.

If this is the case, then additional motivation such as the option holder want the ownership of the stock (to vote on AGM for example) or other special offer exists, then it will be more profitable for option holder to just exercise the option.

If the option is still out of the money:

Example 3

For example: let say we have:

• call option with $9.5 strike price
• Current price is $9
• the dividend will be 10cents
• the option price is now 30c (all time value 30cents, no intrinsic value) with 2 weeks to go
• Hence, ex-date price is likely about $8.9 ($9 – 10 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital loss: -60c  ($8.9 expected market value on ex date, minus $9.5 strike price)
• Dividend: 10c
• Total loss: 50c plus the buying price of option

If he/she just sell^(*) the option, profit will be 30c minus the buying price of the option.

Hence, it is very unlikely that the option will be exercised.

Example 4

For example: the same as Example 3 above, except:

• the dividend will be 70cents
• the call option price is now 10c (time value 10cents, no intrinsic value) with 1 weeks to go
• Ex-date price is likely about $8.3 ($9 minus 70 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital loss: $1.2  ($8.3 expected market value on ex date, minus $9.5 strike price)
• Dividend: 70c
• Total loss: 50c plus the buying price of option

If he/she just sell^(*) the option, profit will be 60c minus the buying price of the option.

Hence, it is also very unlikely that the option will be exercised .

Note: (*) option need to be sold 1 day before ex date (on the decision day whether to exercise the option or just sell the option) before the price adjusted due to ex-dividend price behavior

Conclusion

If dividend is distributed in the middle of option period:

1. For out-of-the-money call option: the option will not be exercised
2. For in-the-money call option, if there is no special circumstances, option will not be exercised as well as it is more profitable for option holder to just sell the option to the market.
3. But if the motivation of the option holder is to own the stock , additionally the time value is not that significant and the profit from capital gain/dividend is not trivial (compare to the time value), then the in-the-money call option will be exercised before ex-date.

Denis Kristanda