Q&A
Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. Contributing analysis is by senior Optionetics strategist Chris Tyler.
PAYING THAT PAYOUT?
If I purchase a protective put against a stock that’s set to pay a dividend, am I obliged to cover the dividend? What do I need to do in order to make sure I collect the payout?
The good news is that a holder of long stock protected by a long put doesn’t need to do anything in front of the ex-dividend date in order to receive the shareholder payout. The dividend is actually priced into the put in front of the event. If this weren’t the case, there would be the proverbial but unlikely free lunch on Wall Street available.
Directionally speaking, as long as you like this position — which is called either a synthetic long call or married put and maintains long deltas — you’ll want to hold it through the ex-date, or forfeit the dividend and/or give up the position’s protection afforded by the put. To illustrate, we’ll use a dividend scenario with a stock called Xyz that trades for $100 and is set to go ex-dividend the next day with a quarterly payout of $5.00 per share.
Immediately in front of the ex-dividend event, a trader wants to own shares in order to collect the $5.00 payout. However, not wanting to have open-ended downside exposure, the trader purchases a deep in-the-money 115 put that has a couple of days remaining until expiration. Without the forthcoming payout, the deep put typically would trade like stock and be priced for the intrinsic value of $15. Interest costs are irrelevant, as would be the vega or volatility component under most circumstances not involving situations with implieds through the roof.
In this example, the trader is looking at a fair value purchase of $20 per contract. The extra $5.00 reflects the price of the dividend with the assumption the put acts as a stock proxy with a near (-100) delta. Some simple math dictates this pricing; otherwise, there’d be arbitrage opportunities to bring the component prices back in line.
If the put traded for $15 or intrinsic value in front of the ex-dividend with shares priced at $100, this would spell a nice opportunity. With a bit of directional risk involved, an investor could buy the put naked. The next day, he or she would be able to sell that same put for its new intrinsic value of $20 if the stock opened unchanged, but reflecting the removal of the dividend from its share price.
In the real world, the mathematical reality is that the put will change hands around or exactly at its fair value of $20 in front of the ex-date. At the next session, if the stock opens unchanged but without the dividend at $95, the put will remain priced at $20 to reflect the intrinsic value of the contract, netting the trader a scratch if he or she merely bought the put naked long.
As for our married-put strategist who also owns shares, while they also scratch on the put, the trader will receive the dividend of $5.00 when it’s eventually paid out. Of course, they paid $100 for shares now trading for $95, but that’s another discussion involving less math and more financial smoke and mirrors.
WEDDED BUT AT ODDS
I’m baffled by the pricing my broker gives when looking at the married put combo. Shouldn’t it be priced like a long call since the risk is the same?
Your broker is pricing the long stock/long put combination based on its actual dollar cost in a cash account rather than the capital at risk. Margin accounts have the luxury of appreciating risk reduction as the reduced outlay for shares makes the strategy less prohibitive but more expensive than buying an equal number of limited risk, long calls.
It would be nice to see the day when cash accounts might enjoy the benefits of larger portfolio, risk-based accounts that make the distinction with regards to this position type. In the end, a married put has the same risk properties of the long call, and having brokers uniformly applying that factor to all types of investor accounts makes sense for all involved.
RIDING A CORRECT CALL
What are your thoughts on staying in a winning long call position?
There’s an old saying that refers to letting your winners run. We agree to a certain point — that point being a reasonable amount as dictated by a percentage return such as half of your initial investment. When a long call gets to certain levels of profitability like 50%, there are typically strong opportunities to adjust into a better-suited position without the risk of giving those profits back.
Most simply, a trader long a call with open profits could exit a percentage of the position. In selling out some but not all of the contracts, he or she can lock in a guaranteed profit while maintaining upside exposure. Similarly but using options, the trader might consider establishing a nicely priced vertical by selling a higher strike call.
Another choice could be to close the entire position, take a portion of those profits, and roll out and up. This would allow the trader to ride what’s been a winning position longer than otherwise. All told, there are plenty of options in letting a winner continue to run but more smartly if your outlook remains optimistically predisposed.