The Best Way to Play Dividends? Leave Them Alone!

At some point, early in our trading career, we have all had the thought… let’s try to “capture” a dividend. And why not? It seems as if they’re just sitting there, ripe for the picking. But any knowledgeable option trader knows that attempts to take advantage of this mirage are futile. So while we’re not supposed to dampen the hopes of the everyday folks who are plotting their escape from deep inside a black hole, it’s important to recognize that hope is good, but futility deserves the occasional reminder. Let’s walk through an example:

Consider the case of Lockheed Martin (LMT). On August 29, the stock is trading at $91.92 and the option chain looks like the one below:

The ex-dividend date is August 30 – the following day. Therefore, a new trader may attempt to “capture the dividend” via the purchase of a collar. Specifically, suppose a trader buys the stock for $91.92, buys the 90-strike put for $1.00, and sells the 92.50-strike call at 65 cents. The idea is to buy the stock (to “capture the dividend), to buy a put (for protection), and to sell a call option (to help pay for some of the put purchase).

Given just enough knowledge to be dangerous, this sounds brilliant. BUT, let’s see what happens the next day…

On August 30, the stock closes at $90.93 per share. So let’s explain what happened with the help of the following option chain that shows the closing markets on August 30. 

First, note that the change in the stock from August 29 to August 30 is minus 99 cents (from 91.92 to 90.93). However, the net change on the day is correctly shown to be plus one cent!

You see, LMT pays that pesky $1.00 dividend, and upon payment, the stock MUST be adjusted $1.00 per share lower in order to reflect that $1.00 per share is no longer part of the company. That’s easy enough. However, the stock didn’t close exactly one dollar lower. It only closed 99 cents lower. That one cent represents the change in the day outside of any adjustments.

Think about it. When a stock has a 2 for 1 stock split, you don’t see the change in the day as half of the stock price. The adjustment is not part of the daily change.

But back to this dividend thing…

Because the stock pays a periodic dividend, and because everyone knows this, the options are adjusted to reflect an upcoming dividend. Once the dividend has been paid out, there is no more need to adjust the options, so the adjustments are taken out. But the adjustment in option prices is only designed to offset the adjustment in the stock (I know, this is getting complicated, but hang in there).

The simple explanation is that as you can see from the option chain on August 30, the options have barely changed in value. In fact, the only noticeable change is that both the call and the put are a few cents higher than they were the previous day. That’s not even enough to cover either your commissions or your bid-ask spread, much less both.

As for the stock that you bought, it is lower by one dollar…the same dollar that you received in a dividend payment. So after all that work, things are unchanged, as they should be in a world without free money.

To conclude, the idea of “capturing” dividends, and of somehow getting something for nothing is extremely alluring, and there will be no shortage of folks continuing to tell you that this time they really, really have a method that works. Just keep in mind that the civilized world eventually stopped trying to turn lead into gold via alchemy, so there is evidence of progress, and hence hope that efforts will continue to be directed to more realistic and hence useful endeavors.

Be careful out there,

Alex Mendoza