Effect of Dividends on Option Pricing

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How dividend affects stock and option prices

If your trading strategy is based on income generation, you could possibly tend to prefer companies that issue dividends. And why wouldn’t you like some extra payout every once in a while? But, before you decide to opt for choosing your investments, it’s vital that you understand how dividends fit into your portfolio and why they make a difference to the market.

How Dividends Affect Stock Price

Based on the type and size of the dividend, its impact on the stock price can easily last temporarily or indicate a change in a long-term trend.

When a company makes a profit and makes a decision to issue a dividend, the company’s stock price can potentially be impacted in different ways:

Ex-Dividend Date

When a company announces a dividend, the stock is believed to trade “with the dividend.” If you buy the stock, you will get the dividend. The ex-dividend date is the 1st day the stock trades without the dividend. If you purchase the stock on or after that date, you will not receive the dividend, which will be paid to the previous owner — the seller you purchased the stock from. On the ex-dividend date, the stock price drops by the amount of the dividend but gradually drifts back to its old level over the next several days.

When Dividends Go Down/Up

If a company drives down the dividend it pays on its stock, the stock becomes unappealing to traders. That means that the price of the stock will drop. If you own this stock, you will not only earn a lower dividend, but you are also going to watch your share prices fall. The market reacts very fast to dividend fluctuations, so even a hint of a dividend cutback can cause your stock to go down in price.

When dividends go up, the stock starts to become more appealing to buyers. That increased demand allows sellers to raise the price to gain more profits. If you maintain this dividend stock, the share price will go up as the dividend rises. Investors usually consider rising dividends a sign of a company’s well-being. Always be certain the company that issues the dividend stock reports growing profits alongside the increased dividend. Stay away from companies that significantly raise their dividends without increased profits to make their stock look more appealing, mainly because those companies might not be able to pay the increased dividend over time.

Special Dividend

A company may come into a surprisingly large amount of fast cash either via the sale of a subsidiary or a court settlement. It may decide to distribute the cash to the shareholders as a special one-time dividend. If the dividend is large enough in regard to the size of the company, the stock price will likely be revised completely. For example, ABC, which is currently at ₹100 a share, announces a special ₹50 dividend. The good news might possibly push the stock price higher — some investors may simply want to invest in it to earn the cash. Once the stock goes ex-dividend, the price will drop by ₹50 and the adjustment will be permanent.

In the above figure you can see that ITC moved higher by approx.4% on the Bombay Stock Exchange after the board announced a special dividend of ₹ 8.50 (including special dividend of ₹ 2) per share for the year ended March 31, 2020.

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Effects of Dividends on Options

As stated before, a dividend payment could decrease the price of a stock resulting from reduction of the company’s assets. It becomes instinctive to know that if a stock is predicted to go down, its call options will certainly drop in extraneous price while its put options will gain in extraneous price before it happens.

Each and every time a dividend is announced on a stock, the market discounts the dividend in the market price of the stock and as a result the ex-dividend price of the stock is lower. This price adjustment in turn affects the price of the options. Both call and put options are impacted by the ex-dividend rate.

Effect on Call Option

In case of a call option, the premium decrease with the declaration of dividend. On the ex-dividend date the market price adjusts for the cash dividend declared. Since the price of the stock drops on the ex-dividend date, the value of call options also drops in the time leading up to the ex-dividend date.

Effect on Put Option

The opposite happens in the case of put options. Put options gain value as the price of stock goes down. Put options get more expensive due to the fact that stock price always drop by the dividend amount after ex-dividend.

Although dividends are not the primary factors affecting an option’s price, the option trader should still be aware of their effects.

Options Pricing- Key Factors & Impact on Option Premium Price

Published on Wednesday, April 4, 2020 by Chittorgarh.com Team | Modified on Friday, November 8, 2020

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Before getting started with trading options, you should have a good understanding of options pricing and the various factors that play a role in establishing the value of an option. There are also several option pricing models that are used to identify the value of a call or a put option. A solid understanding of options pricing factors and models will help you take advantage of price movements and optimize your earnings from your investments.

Understanding option pricing (Option Premium Explained)

Option pricing is the amount per share you have to pay to trade an option. The price of an option is also known as the premium. The buyer of an option needs to pay the premium amount to the seller to earn the rights granted by the option. Option premiums are priced per share.Since options are available in lots of shares called lot size, you need to pay:

Total Premium Amount= (premium price per share) X (lot size)

For example, say TCS option with a strike price of в‚№2,500 is available at a premium of в‚№20 per share for a lot size of 100 shares. To buy the option, you need to pay a premium amount of в‚№20 X 100 = в‚№2,000. The premium paid is non-refundable whether you choose to exercise your option or not.

What are the main factors determining an Option’s Price or Premium?

There are many factors that influence the price of an option:

1. Value of the option’s underlying asset

As we know, options are derived from underlying instruments like shares, gold, currency etc. The current value or price of the option’s underlying instrument has a direct effect on the price of the call or put option. If the value of the underlying instrument is on the rise then the call option price will increase and put option price will decrease. If the price of the underlying instrument decreases then call option price will decrease and put option price will increase.

2. Intrinsic Value of an Option

Intrinsic value refers to the value of the option if it were exercised today. It is calculated as a difference between the price of the underlying instrument from which the option is derived and strike price. The strike price is the price at which a buyer and a seller decided to enter the contract.

For call options, intrinsic value is calculated as-

Intrinsic Value = Spot Price – Strike Price

For put options, intrinsic value is calculated as-

Intrinsic Value = Strike Price – Spot Price

The intrinsic value of an instrument can only be positive and zero. It cannot be negative.

The intrinsic value of an option helps you in determining the profit advantage in case you wish to exercise the option immediately. It can be also called as the minimum value of an option.

3. Time Value of an Option

It is calculated as the difference between premium and intrinsic value.

Time Value = Premium-Intrinsic Value

The time value is directly related to how much time an option has until it expires. Generally, the longer the time for an option to expire, the higher is the premium. And it decreases as you come closer to the expiry date of the option.

4. Volatility

Volatilityis the probability of the price fluctuation (up or down) of the underlying instrument in the market. The higher the volatility of the underlying instrument, the higher the premium. It is because highly volatile stocks have a higher possibility of bringing profits to investors in a short time.

Volatility is of two types- historical and implied. Historical volatility measures the fluctuations observed in an underlying instrument in the past. Implied volatility predicts the fluctuations in the future.

5. Interest Rates

Normally interest rates have nominal influence on options pricing. But it can be a factor if you are trading in options of large size. There is no direct effect of interest rates on options pricing. Its effect is related to the cost of funds. Let’s assume that to trade in a large options contract, you decide to borrow money from banks or use funds from your savings that are earning some interest rates. Whichever way you go, you are paying interest on the loan or losing interest in case of savings. So the cost of your funds now is invested amount plus the interest on it. If the interest rate is high then the cost of money invested is also high. So when interest rates are high, the premium falls and vice versa.

6. Dividends on underlying stocks

In the event of dividend announcements during the life of an option, the exchanges adjust the option positions. As per regulations by SEBI, if the value of the dividend is more than 10% of the spot price of the option on the date the dividend is announced, then the strike price of the options are reduced by the dividend amount on ex-dividend dates. For dividends announced lower than 10% of the spot price, there is no adjustment by the exchange. Dividend announcement decreases the value of the option as the stock value decreases on the ex-dividend date.

Option Pricing Models

What are Option Pricing Models?

Option Pricing Models are mathematical models that use certain variables to calculate the theoretical value of an option Call Option A call option, commonly referred to as a “call,” is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock or other financial instrument at a specific price – the strike price of the option – within a specified time frame. . The theoretical value of an option is an estimate of what an option should be worth using all known inputs. In other words, option pricing models provide us a fair value of an option. Knowing the estimate of the fair value of an option, finance professionals Guide to Becoming a Financial Analyst How to become a financial analyst. Follow CFI’s guide on networking, resume, interviews, financial modeling skills and more. We’ve helped thousands of people become financial analysts over the years and know precisely what it takes. could adjust their trading strategies Trade Order Timing – Trading Trade order timing refers to the shelf-life of a specific trade order. The most common types of trade order timing are market orders, GTC orders, and fill or kill orders. and portfolios. Therefore, option pricing models are powerful tools for finance professionals involved in options trading.

What is an Option?

A formal definition of an option states that it is a type of contract between two parties that provides one party the right, but not the obligation, to buy or sell the underlying asset at a predetermined price before or at expiration day. There are two major types of options: calls and puts.

  • Call is an option contract that gives you the right, but not the obligation, to buy the underlying asset at a predetermined price before or at expiration day.
  • Put is an option contract that gives you the right, but not the obligation, to sell the underlying asset at a predetermined price before or at expiration day.

Options may also be classified according to their exercise time:

  • European style options may be exercised only at the expiration date.
  • American style options can be exercised anytime between purchase and expiration date.

The above-mentioned classification of options is extremely important because choosing between European-style or American-style options will affect our choice for the option pricing model.

Risk-neutral Probability

Before we start discussing different option pricing models, we should understand the concept of risk-neutral probabilities, which are widely used in option pricing and may be encountered in different option pricing models.

The risk-neutral probability is a theoretical probability of future outcomes adjusted for risk. There are two main assumptions behind this concept:

  1. The current value of an asset is equal to its expected payoff discounted at the risk-free rate.
  2. There are no arbitrage opportunities in the market.

The risk-neutral probability is the probability that the stock price would rise in a risk-neutral world. However, we neither assume that all the investors in the market are risk-neutral, nor the fact that risky assets will earn the risk-free rate of return. This theoretical value measures the probability of buying and selling the assets as if there was a single probability for everything in the market.

Binomial Option Pricing Model

The simplest method to price the options is to use a binomial option pricing model. This model uses the assumption of perfectly efficient markets. Under this assumption, the model can price the option at each point of a specified time frame.

Under the binomial model, we consider that the price of the underlying asset will either go up or down in the period. Given the possible prices of the underlying asset and the strike price of an option, we can calculate the payoff of the option under these scenarios, then discount these payoffs and find the value of that option as of today.

Figure 1. Two-period binomial tree

Black-Scholes Model

The Black-Scholes model is another commonly used option pricing model. This model was discovered in 1973 by the economists Fischer Black and Myron Scholes. Both Black and Scholes received the Nobel Memorial Prize in economics for their discovery.

The Black-Scholes model was developed mainly for pricing European options on stocks. The model operates under certain assumptions regarding the distribution of the stock price and the economic environment. The assumptions about the stock price distribution include:

  • Continuously compounded returns on the stock are normally distributed and independent over time.
  • The volatility of continuously compounded returns is known and constant.
  • Future dividends are known (as a dollar amount or as a fixed dividend yield).

The assumptions about the economic environment are:

  • The risk-free rate is known and constant.
  • There are no transaction costs or taxes.
  • It is possible to short-sell with no cost and to borrow at the risk-free rate.

Nevertheless, these assumptions can be relaxed and adjusted for special circumstances if necessary. In addition, we could easily use this model to price options on assets other than stocks (currencies, futures).

The main variables used in the Black-Scholes model include:

  • Price of underlying asset (S) is a current market price of the asset
  • Strike price (K) is a price at which an option can be exercised
  • Volatility (σ) is a measure of how much the security prices will move in the subsequent periods. Volatility is the trickiest input in the option pricing model as the historical volatility is not the most reliable input for this model
  • Time until expiration (T) is the time between calculation and an option’s exercise date
  • Interest rate (r) is a risk-free interest rate
  • Dividend yield (δ) was not originally the main input into the model. The original Black-Scholes model was developed for pricing options on non-paying dividends stocks.

From the Black-Scholes model, we can derive the following mathematical formulas to calculate the fair value of the European calls and puts:

The formulas above use the risk-adjusted probabilities. N(d1) is the risk-adjusted probability of receiving the stock at the expiration of the option contingent upon the option finishing in the money. N(d2) is the risk-adjusted probability that the option will be exercised. These probabilities are calculated using the normal cumulative distribution of factors d1 and d2.

The Black-Scholes model is mainly used to calculate the theoretical value of European-style options and it cannot be applied to the American-style options due to their feature to be exercised before the maturity date.

Monte-Carlo Simulation

Monte-Carlo simulation is another option pricing model we will consider. The Monte-Carlo simulation is a more sophisticated method to value options. In this method, we simulate the possible future stock prices and then use them to find the discounted expected option payoffs.

In this article, we will discuss two scenarios: simulation in the binomial model with many periods and simulation in continuous time.

Scenario 1

Under the binomial model, we consider the variants when the asset (stock) price either goes up or down. In the simulation, our first step is determining the growth shocks of the stock price. This can be done through the following formulas:

h in these formulas is the length of a period and h = T/N and N is a number of periods.

After finding future asset prices for all required periods, we will find the payoff of the option and discount this payoff to the present value. We need to repeat the previous steps several times to get more precise results and then average all present values found to find the fair value of the option.

Scenario 2

In the continuous time, there is an infinite number of time points between two points in time. Therefore, each variable carries a particular value at each point in time.

Under this scenario, we will use the Geometric Brownian Motion of the stock price which implies that the stock follows a random walk. Random walk Random Walk Theory The Random Walk Theory or the Random Walk Hypothesis is a mathematical model of the stock market. Proponents of the theory believe that the prices of means that the future stock prices cannot be predicted by the historical trends because the price changes are independent of each other.

In the Geometric Brownian Motion model, we can specify the formula for stock price change:

ΔS – change in stock price

µ – expected return

σ – standard deviation of stock returns

Unlike the simulation in a binomial model, in continuous time simulation, we do not need to simulate the stock price in each period, but we need to determine the stock price at the maturity, S(T), using the following formula:

We generate the random number and solve for S(T). Afterward, the process is similar to what we did for simulation in the binomial model: find the option’s payoff at the maturity and discount it to the present value.

Effect of Dividends on Option Pricing

Before starting your options trading journey, you should have a good understanding of the key factors that determine the value of an option. These include the current stock price, time until expiration, implied volatility, the intrinsic value, interest rates and dividends (lesser effect).

Sounds like a lot at first but once you break it down, it’s quite simply really.

Thankfully we’re not going to hand calculate the Black-Scholes option pricing model – your safe there huh? Of course it’s good to know, but gaining the essential knowledge is more important than boring you to death. So, we would rather focus on the inputs or option pricing as opposed to the calculations.

This 10-part series will provide you with rock-solid guidance that will have you analyzing options better in no time.

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  • 4 Must Know Options Expiration Day Traps to Avoid
  • Trading Calendar Option Spreads – How To Use Time Decay To Your Advantage
  • 10 Reasons Why Options Trading Liquidity Should Be A Top Priority
  • Options Don’t Expire On The Third Friday Of Every Month (Technically)
  • 4 Ways You Can Trade Weekly Options In Your Portfolio
  • Profit From Unusual And Abnormally High Options Trading Volume
  • Understanding The Max Pain Theory Near Options Expiration
  • 5 Ways To Reduce Your Trading Commissions
  • How Can I Exit A Vertical Option Spread Without Getting Creamed?

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It can be a complicated affair if you do not take the time to understand the terminology and concepts of options before trading them. Thus many people simply have no idea at all of what Theta is, while others, searching for an explanation of some sort, end up associating it incorrectly.

Interestingly enough, all of the factors that effect option pricing are known except volatility – which is estimated as future/implied volatility. Thus the effect of option volatility is the most subjective and honestly the most difficult input to quantify and yet the most important.

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