Who Gets the Dividend on a Call Option?

Financial markets offer various instruments, each with unique ownership and return characteristics. Stocks represent ownership in a company, and when a company performs well, it may distribute a portion of its profits to shareholders in the form of dividends. Options, on the other hand, are financial contracts that derive their value from an underlying asset, such as a stock. These contracts grant the holder the right, but not the obligation, to buy or sell an asset at a predetermined price within a specific timeframe. Understanding the interplay between these instruments, particularly concerning dividend payments, is important for investors.

How Dividends are Paid on Stocks

Companies often return profits to shareholders through dividend payments. This process involves several important dates. The declaration date is when a company’s board announces its intention to pay a dividend.

Following the declaration, the ex-dividend date is established as a cutoff for dividend eligibility. To receive the announced dividend, an investor must own the stock before this date. If shares are purchased on or after the ex-dividend date, the buyer will not receive the payment, as the seller retains that right.

The record date usually follows the ex-dividend date. On this date, the company identifies shareholders entitled to receive the dividend. Only those whose names appear on the company’s books by the record date will receive payment.

Finally, the payment date is when the company distributes the dividend funds to eligible shareholders. These dividends are typically paid in cash. Dividends are generally reported to shareholders on Form 1099-DIV for tax purposes.

Dividend Rights of Call Option Holders

Holding a call option grants the right to purchase shares at a specified price, but it does not confer direct ownership benefits. Consequently, a call option holder does not automatically receive dividend payments. Dividends are distributed solely to the registered owners of the underlying stock as of the ex-dividend date.

The individual who wrote the call option, the option seller, usually owns the underlying shares. If the option writer holds the stock through the ex-dividend date, they will receive the dividend payment. Their obligation is to deliver the shares if the option is exercised, not to pass on dividend payments to the option holder.

An unexercised call option does not entitle the holder to dividend income. The option holder only benefits from a dividend if they become the stock’s owner. This requires exercising the option.

Exercising Call Options for Dividend Capture

An American-style call option, exercisable at any time before expiration, allows a holder to potentially capture a dividend. This strategy involves exercising the option to acquire shares before the ex-dividend date. Upon exercise, the option holder becomes the stock’s legal owner, gaining dividend eligibility.

Exercising a call option requires the holder to pay the strike price for each share, plus any associated commissions or fees. For instance, if an option gives the right to buy 100 shares at a strike price of $50, the holder would pay $5,000 to acquire the shares. Brokerage firms may charge a commission for exercising options. These fees vary by firm and number of contracts.

Before proceeding, an investor must evaluate whether the dividend amount justifies the cost of exercising and the potential loss of the option’s time value. An option’s premium includes both intrinsic value and time value. Exercising early means forfeiting any remaining time value, which can be a substantial portion of the option’s overall price.

The captured dividend will be subject to taxation. Dividends received are categorized as either “ordinary” or “qualified” for tax purposes. Ordinary dividends are taxed at an individual’s regular income tax rate. Qualified dividends are taxed at lower long-term capital gains rates, typically 0%, 15%, or 20%. If the stock is sold too quickly after exercising, the dividend might be taxed as ordinary income, reducing the net benefit.

How Dividends Affect Call Option Prices

Dividend announcements and payments influence the underlying stock price, which impacts call option values. When a company distributes a dividend, its stock price is expected to decrease by approximately the dividend amount on the ex-dividend date. This adjustment occurs because the dividend value is no longer part of the company’s assets.

Since a call option grants the right to buy the underlying stock, a decrease in the stock’s price generally reduces the call option’s value. Option pricing models account for expected future dividends by adjusting the underlying stock price downward. This means a call option’s theoretical value will be lower for a dividend-paying stock compared to a non-dividend-paying stock, all other factors being equal.

While dividends benefit stock owners, they generally have a depressive effect on call option prices. The expectation of a future dividend payout is often priced into the option’s premium, reflecting the anticipated drop in the stock’s value on the ex-dividend date. This is a consideration for option traders evaluating call options on dividend-paying stocks.