Extraordinary Items

[bigbadrob]

I am considering trading options and have just been told by my broker that should extraordinary items occur this would effect the option price after the contract was entered into. As an example, open a put option at $45 an unusual dividend is announced, say $5 and the option automatically get downgraded to $40, the original $45 less the $5 extraordinary item.

It sounds to me like my broker is trying to jive me, I just don't see how this can be correct. If it is then why would anyone want to trade in a product that can be changed at any time?

Has any options traders ever heard or experienced this?

Thanks

 

[grantx]

Rob,

If that's the sum total of your broker's knowledge, ditch him and find someone a little more sophisticated. Who's the broker? Come on, name and shame.

You'll find all you want (and not want) to know on these boards. Ask away.

Grant.

 

[bigbadrob]

Not going to name and shame at this point as I didn't get to ask him to expand. Let’s see what he says later.

Looking for option strategy on maximising dividend payments. Any suggestions?

 

[grantx]

Rob,

Maybe he was thinking of 'exceptional items' and 'extraordinary items' as per company accounts. Typical, conservative (ie ignorant) stockboker. His fear is you losing money and thus denying him his commission stream.

As dividends are generally known in advance, I can't think of any option strategy to enhance this. Your broker is correct in that theoretically, a put (and call) option will reflect, ie discount, an expected dividend. However, given the annual yield is probably around 3.5%, an option contract will usually only capture the interim or final dividend, ie at most half or 1.75% (I'm assuming a 9-month option max). Given the variability of stock prices, plus the volatility of the option prices, and commissions, the dividend is almost an irrelevance.

Presumably, if your interested in dividends, then you are holding stock. Therefore, you can increase the overall yield by writing calls against the underlying stock. For example, a stock is 100, and pays 5p dividend for yield of 5%. You could write a call option against the stock, receive the option premium, say 10p, and achieve a risk-free yield of 15%. Of course, if the stock rockets you could lose out but that's the pay-off - certainty for uncertainty. However, the option premium (and dividend) are also providing 15 points downside protection.

Grant.

 

[Profitaker]

I am considering trading options and have just been told by my broker that should extraordinary items occur this would effect the option price after the contract was entered into. As an example, open a put option at $45 an unusual dividend is announced, say $5 and the option automatically get downgraded to $40, the original $45 less the $5 extraordinary item.

The options contract is always adjusted whenever a corporate action is announced, so that neither the option buyer or seller lose out because of it. Normally the options contract is adjusted using a ratio method based on the share price at the close on the day before the corporate action.

Typically the ratio would be calculated;

ABC share price – special Div
----------------------------------------
ABC share price

Then the ratio is applied to the contract size and strike price.

In your example

$ 45 - $ 5
------------ = Ratio 0.89
$ 45

The lot size would then be adjusted by dividing by factor of 0.89, and the strike price adjusted by multiplying by the same factor, and we’re all square.

Like Grant, I would avoid a broker that didn’t know this basic options stuff.