When a company earns a good profit, the company management decides to distribute a part of the profit with its shareholders, this part of profit distributed by a company to its shareholder is called a dividend. Dividends are a type of income for shareholders especially for those who are looking for a steady source of income or are retiring. However, young investors who may not require the income can put those dividends by reinvesting them for the portfolio. Dividend affects the options prices. Therefore as an options trader, one should have in-depth knowledge of dividends. Options traders should know about the dividend and option price. In his blog, we have discussed what is dividends or dividend meaning and How Dividends Affect Option Prices. Along with that we also have covered types of dividends, how is the dividend calculated? What is the dividend yield and dividend yield formula? Why do companies pay dividends? Who is eligible to get dividends? Etc. By going through this blog you will get to know about the connectivity of dividend and option price.
This Blog Covers
What is the dividend?
What are the types of dividend?
Why do companies pay dividends?
Who is eligible to get dividends?
How is the dividend calculated?
What is the dividend yield formula?
How do dividends affect option price?
What Is Dividend Or Dividend Meaning?
When a company earns a good profit, the company management decides to distribute a part of the profit with its shareholders, this part of profit distributed by a company to its shareholders is called a dividend. Distributing a dividend is not obligatory for any company. It solely depends on the company if they want to distribute dividends or they want to invest the additional profit for the company's growth. Companies often pay dividends quarterly or semiannually or annually. Dividend and option price are closely related to each other. We will discuss it later in this blog.
Types of Dividends
There are various forms of dividends available but the following two are the most common forms of dividends,
Cash dividends are being paid in direct cash amount. For example, a company decides to pay ₹1 dividend per share. If a shareholder holds 100 shares of the company then he will be paid with the direct cash amount of ₹. 1x100 = 100 as a dividend.
In stock dividends, instead of paying cash amounts dividends are paid in the form of stocks. For example, if a company decides to pay a 30% stock dividend and if a trader holds 100 shares of the same company then he/she will get a stock dividend equal to 30%. Instead of receiving direct cash shareholders get extra shares.
Why Do Companies Pay Dividends?
Paying dividends to shareholders from time to time shows the positive financial health of the company. Companies having excess cash reserved generally paid dividends to attract their investor's interest in the stock. Investors may consider it as a sign of strength and positive expectations for future earnings and invest more in the company. Stock transactions take a few days to clear, and to ensure the accurate allocation of dividends, there is a cut-off before the record date called the ex-dividend date. Investors require to purchase a stock at least a couple of days before the record date to officially own it in time to be eligible to receive the dividend.
Who Is Eligible To Get Dividends?
Stock transactions require some time to get settled. Therefore to decide the eligible shareholders to whom the company wants to pay the dividend, companies make use of two cut off dates,
Record date: What is record date? Record date is simply a cut-off date decided by the company to determine which shareholders will be eligible to receive dividends. On the record date, the company checks its records to identify shareholders of the company.
Ex-dividend date or ex-date: What is ex-dividend date or ex-date? The ex-dividend date or ex-date is the date on which a cut-off period is marked within which investors can purchase stock to receive the upcoming dividend payment. If the investor owns shares the day before the ex-dividend date, he/she will receive the next dividend payment.
Owning a stock on the day its dividend is paid doesn't necessarily mean you'll receive the dividend. In order to receive a dividend from a company, you must be a shareholder before the record date. Investors buying the stock on or after the ex-dividend date are not eligible to receive the upcoming dividend.
Instead of receiving dividends as cash, you can also opt for an automatic dividend reinvestment plan, or DRIP, for eligible securities in which cash gets converted into the extra share of the company.
How Is The Dividend Calculated?
Let’s see how is the dividend calculated? The dividend per share is calculated as the total dividend divided by the outstanding shares. So the formula for calculating dividend per share is,
Dividend per share = Total dividend ÷ Outstanding shares
For example, a company decides to distribute a total dividend of rupees 4000. At that time the total number of outstanding shares is 1000. So the dividend per share will be,
Dividend = 4000 ÷ 1000 = 4 rupee per share
The dividend per share is an important metric as it allows the investor to determine the amount of cash they will get based on shares they hold.
What Is The Dividend Yield And Dividend Yield Formula?
There are many measures that help investors understand how much return they are getting on their investment. The dividend yield is one of those measures. Dividend yield tells how much a company pays out in dividends each year relative to its stock price. Dividend yield of a company which is distributing dividends can be calculated by dividing the expected income i.e. the dividend by what you invest i.e. the price per share. So the formula for calculating dividend yield is,
Dividend yield = Annual dividend per share ÷ Price per share
For example, Take two companies that both pay ₹1 per share. One’s stock price is at ₹30, and the others at ₹20. The first company's dividend yield is 4.4%, and the dividend yield of other company is 6%. The company with a higher yield looks like a better investment because it shows a 6% return.
Some healthy companies pushes the shares up prior a dividend increase, which would lower the dividend yield. At average or distressed company with falling shares price and unchanged dividends, the dividend yield would go up. But that dividend payment might soon be reduced or even canceled by the board. It is necessary for the investors who are looking for a stable dividend yield should understand factors affecting the dividend yield, and focus on established companies with a history of both consistent earnings and growing dividends. Traders should understand the relation between dividend and option price before investing in any high- dividend-paying company.
How Dividends Affect Option Price
Option dividends will impact the price of options and the reason behind it is that, they will impact the returns of the underlying. So, whenever a company pays a dividend under normal circumstances you would expect the price of the stock to fall by the amount of the dividend paid and obviously, therefore a dividend being paid decrease the value of a call option on that underlying and increase the value of a put option on that underlying. Both call options and put options get impacted by the ex-dividend date.
As the price of the stock goes down Put options price increases. Holder of a put option has the right to sell 100 shares of stock at the specified strike price up until the expiration of the option. The seller of the option has the obligation to buy the underlying stock at the strike price if the option is exercised. The seller collects a premium for taking this risk.
On the other hand, the price of the call options decreases in the days leading up to the ex-dividend date. The buyer of a call option has the right to buy 100 shares of the stock at a specified strike price up until the expiration date. 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.
When dividends are paid stock is generally reduced by the amount of the dividend. So, if we have got a company that is paying a quarterly dividend of ₹ 2 then the stock starts trading without that dividend and therefore the options also will be trading without that dividend attached to it which intern causes the shares of the stock to fall by that dividend amount.
So if the company pays ₹ 2 dividend we would expect shares to come down by ₹ 2.
Higher dividends causes increase in Put premiums and decrease in Call premium. Whereas lower valued dividends causes decreased put premium and increased call premium.
Dividends are a type of income for shareholders especially for those who are looking for a steady source of income or are retiring. However young investors who may not require the income can put those dividends by reinvesting them for portfolio growth. Traders should have an understanding of the relation between dividend and options price. Traders and investors need to understand the dividend yield before investing in high dividend-paying companies. It is necessary for the investors who are looking for a stable dividend yield should understand factors affecting the dividend yield, and focus on established companies with a history of both consistent earnings and growing dividends.