Quick question re Special Dividend and Calls

[oscar23]

Hi guys, I have a quick question that I'd appreciate a bit of help with...

I am hoping that a company I was investing in are going to issue a rather large special dividend... I thought the best way to make the most of this would be to leverage myself up by buying plenty of Calls ... but reading into it I think this might not work because the options are adjusted down... So if ABC issue say a 30% special dividend and the price jumps to reflect this will my Calls gain in accordance or would I be better off just buying straight stock?
Thanks guys,
Osc.

 

[Profitaker]

Oscar

You will neither gain nor lose by taking an option position as any capital returned to shareholders (e.g. special div) is accounted for by the exchange adjusting the option strike price and contract lot size.

Whether the SP will rise or fall if a special div is announced is another debate, based on specific stock sentiment. But you certainly can't profit from the capital element of any special div, unfortunately.

Good luck.

 

[Profitaker]

Oscar,

At a guess, and focusing purely on intrinsic value, the calls will adjust to reflect the value of the underlying at a corresponding yield. For example, the current yield on a 100p stock is 5% or 0.05p, and a special div of 0.20p is announced. The value of the shares should increase to a point where, once again, the yield is 5%. Following payment of the special div they will revert back to the original price with the same yield and original premium.

I would suspect the calls have increased in value on the back of an increase in implied volatility because the mm’s will be cashing-in on possible higher demand. But if the underlying is known to go ex-special div by a certain date (and drops accordingly) will they jack the call iv’s and let sellers rake in the premium or will they jack the put iv’s to dissuade potential buyers?

Grant.

The normal way to account for a special div is to adjust all contracts using the ratio method. The exchange would take the price at the close on the day before ex-div minus the special div and divide by the closing price. The strike is then adjusted by multiplying by the ratio and the contract size by dividing by the ratio.

e.g. Stock price at close day before ex-div is 500
Special Div is 100
Ratio is (500-100) / 500 = 0.8

500 Strike becomes 500 x 0.8 = 400
1000 lot size becomes 1000 / 0.8 = 1250

You should see that a given % gain in the calls before the div is then exactly the same as a given % gain after the div

e.g.

500 x 10% x 1000 = 400 x 10% x 1250

I think any other change in the SP would be down to sentiment and how the market perceived the fact that they were returning cash, rather than investing it.

 

[oscar23]

excellent, thanks for that Profitaker - really appreciate it and definitely important to understand!

Nice signature too

Osc.

 

[grantx]

PT,

I won't dispute your post but it does seem a lot of work (from the exchange) to account for it. The underlying will adjust accordingly, as will the option, without poncing around with contract specs. After all, this is not a scrip or rights issue.

Grant.

 

[Profitaker]

Grant

Well it's entirely up to you as to whether you think the exchange will go "poncing around with contract specs".

Trust me, they do.

 

[grantx]

PT,

I do, they will.

Grant.

 

[Panorama]

They will adjust lotsiz: strikeprice .... but there still is a way to make profit from special dividend.. tip: dividend tax for foreign investors... That all I have to say.

good luck!

 

[Profitaker]

They will adjust lotsiz: strikeprice .... but there still is a way to make profit from special dividend.. tip: dividend tax for foreign investors... That all I have to say.

good luck!

But you'd have a taxable gain (special div) and a capital loss (the stock). Surely either you'd be exempt both (foreign investor possibly) or liable both (UK investor definately) ? But I cannot see how you could make a case for one without the other, foreign investor or not.

Do tell.

 

[Panorama]

Profittaker: Did you follow the Altana case?

 

[Profitaker]

No I didn't.