With the fiscal cliff looming, special dividends have never been more popular. Dozens of companies are making substantial payouts before the end of the year in order to avoid any possibility that current low rates of 15% on qualified dividends won't be available in 2013 and beyond, and in general, shares of companies declaring those dividends have risen as investors applauded the moves.
But for one specialized area of the investing world, special dividends introduce a big headache. Options investors have to check closely when an underlying stock declares a special dividend to make sure they understand the potential impact and make the right moves.
Dividends and options
Options investors are used to having to pay more attention to dividends than most investors. Typically, if you own a stock, you can just sit back and watch dividend payments come into your account. With options, though, dividends raise a question: Should you exercise an option early in order to collect a dividend?
With ordinary dividends, the answer is sometimes yes. Usually, it makes more sense to sell an option back into the market rather than exercise it early, because buyers will be willing to pay at least something for the time value that the option gives them. When a dividend is imminent, though, the time value of holding on to the option may well be less than the amount of the payout. In that case, early exercise makes sense.
Special dividends, though, are another matter entirely. That's because unlike regular dividends, special dividends actually change the terms of the options contract. For instance, consider the changes to options that these recent special dividends have led to:
Costco's recent $7-per-share special dividend led to strike prices on options being adjusted downward by $7. So if you previously held a call option to buy Costco shares for $105 each, it will now allow you to buy those same shares for just $98 if you exercise.
CYS Investments will have its options strike prices adjusted down by the $0.52-per-share special dividend that becomes effective Dec. 19.
Investors in Whole Foods options had a $2 downward adjustment to strike prices made on Dec. 6 to account for the special dividend that investors will receive later this week.
In the casino gaming space, both Wynn Resorts and Las Vegas Sands got special adjustments for their big dividend payouts, with Wynn seeing $7.50-per-share reductions while Sands got a $2.75-per-share reduction.
All this may sound complicated. But the gist of it boils down to this: If you bought an option, you basically get the benefit of the special dividend, because it's automatically reflected in the price of the option. On the other hand, if you were the one to write the option -- such as through a covered-call strategy -- the special dividend payment you'll receive may well be offset by the reduction in the strike price you'll receive per share if the option gets exercised.
Take a closer look
There's no hard-and-fast rule about when a dividend rises to the point at which it becomes special and therefore triggers changes in option terms. For instance, plenty of stocks have double-digit dividend yields based simply on their regular dividend payout rates, but option contract terms don't get amended every quarter when they make payouts. On the other hand, even a relatively small payout could trigger option changes if it's out of the ordinary for the stock involved.
Perhaps the biggest potential pitfall is for covered-call writers. When the strike price of the call option you've written goes down, it increases the likelihood that the option will get exercised and that your shares will get called away. Many investors want to avoid that at all costs, so if you're really concerned about that possibility, you'll want to buy back the call option you wrote to close the option position.
Options can be tricky, and special dividends make them trickier still. But as long as you're aware of the impact that special dividends have on options, you can prepare for whatever happens.
Costco's special dividend is just the latest in moves that have given long-term investors a 100-bagger since the early 1990s. But is the ride over for Costco investors? To answer that, we've compiled a premium research report with in-depth analysis on whether Costco is a buy right now, and why. Simply click here now to gain instant access to this valuable investor's resource.
The article How Special Dividends Can Sink Options Investors originally appeared on Fool.com.
Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Costco and Whole Foods. Motley Fool newsletter services recommend Costco and Whole Foods. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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