As we mentioned in earlier articles, an option’s intrinsic value is the premium value related to the difference between the stock’s price and the strike on the option.
VIoa = max(S – X; 0)
VIov = max(X – S; 0)
In the previous article, we saw that the evolution of interest rates had an impact on the actual value of the strike, and, by extension, on the intrinsic value. This week, we deal with a variable that also has an influence on the intrinsic value of options, and particularly on the value of the underlying: the dividend.
To understand correctly how a dividend can influence options’ value, here is an example of National Bank of Canada (NA) shares that will be paying out a dividend of about $0.56 per share at the end of March 2017.
|Share price on eve of dividend payment by NA||$56.02|
|Intrinsic value: call option with $55 strike||$1.02 $ ($56.02 – $55)|
|Share price after dividend payment by NA||$55.46|
|Intrinsic value: call option with $55 strike||$0.46 ($55.46 – $55)|
By assuming that the NA share price will remain at $56.20 when the dividend is paid, we can see, in the previous table, that the intrinsic value of a call option with a strike of $55 is $1.02. However, the dividend payment lowers the share price by the value of the dividend*.
This is explained by the fact that the dividend payment by NA leads to $0.56 per share leaving the bank’s coffers.
By buying the shares at $56.02 on the eve of the dividend payment, you become eligible to receive the dividend. However, the investor who wishes to buy shares the following day will not benefit from the dividend payment. Therefore, he will most definitely not want to pay $56.02 per share for a company that just lost $0.56 per share in value. So, after the dividend payment, investors will want shares at a price that, to be fair, will have to be brought down to $55.46. As the price of NA shares has just fallen, we can see that its intrinsic value has also gone down to $0.46.
We can say that an increase in dividend will lead to a decrease in the value of call options and, conversely, that a decrease in dividend will increase the value of call options.
For put options, the reverse is true: an increase in dividend, by lowering the share value, will then lead to an increase in the value of put options, while a decrease in dividend will decrease the value of those same options.
Next week, we will conclude this series of articles by discussing the impact of volatility on the intrinsic value of options.
Good luck in your trading, and have a good week!
*For the purposes of this article, we simplified the exercise by lowering the share price by an amount equal to the dividend but, in reality, many factors, including the business’ tax situation, lead to the decrease usually being smaller than the value of the dividend.
The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing options strategies
Monetis Financial Corporation
Martin Noël earned an MBA in Financial Services from UQÀM in 2003. That same year, he was awarded the Fellow of the Institute of Canadian Bankers and a Silver Medal for his remarkable efforts in the Professional Banking Program. Martin began his career in the derivatives field in 1983 as an options market maker for options, on the floor at the Montréal Exchange and for various brokerage firms. He later worked as an options specialist and then went on to become an independent trader. In 1996, Mr. Noël joined the Montréal Exchange as the options market manager, a role that saw him contributing to the development of the Canadian options market. In 2001, he helped found the Montréal Exchange’s Derivatives Institute, where he acted as an educational advisor. Since 2005, Martin has been an instructor at UQÀM, teaching a graduate course on derivatives. Since May 2009, he has dedicated himself full-time to his position as the president of CORPORATION FINANCIÈRE MONÉTIS, a professional trading and financial communications firm. Martin regularly assists with issues related to options at the Montréal Exchange.