How do dividends affect options' theoretical value?
I understand how increasing/decreasing dividends affect a call value for an option, but I'm kind of confused about why higher dividends increase puts while decreasing dividends decrease put values?
Read Natenberg. His book will explain the topic better than you're going to get on a forum (and more in depth).
try this as a start for a quick answer..but i agree with the above for deeper understanding
http://www.theoptionsguide.com/effect-of-dividends-on-option-pricing.as…
When dividends are paid out usually stock value will fall, thus the put value increases. It driven from the idea that when the stock price gets closer to the strike price the option value increases, so when the stock price drops the value of the put increases.
It also has to do with the fact of how an option price is derived. With a call option, the holder of the option will loose out on the dividend by not holding the stock so therefore the present value of the dividend is subtracted from the option price. And for the put, its like what 'non-target' said.
What I don't understand is how you can state that you understand the impact of dividends on call value but not on put value. It's just the same: a change in expected dividends impact the forward price of the stock. The difference between the forward price and the strike price is the basis on which you build the option value.
There's more to it than this, particularly re: American and European exercise rights. Agree with above posters that you should read Natenberg.
First of all, if something affects calls, then it MUST also affect puts because of put-call parity. This is a no arbitrage condition that must always hold.
Beyond that, think about what is actually going on with both a call and a put.
A call option gives the buyer long exposure to the upside return on the stock, but does not allow you to enjoy the return from dividends. For reasons we won't go into here, that concept is calculated as the risk free rate minus the dividend yield. If dividends are higher, you are losing out on receiving more FCFs of the company, so too bad for you and you'd want to pay accordingly less for the option.
The put is just the opposite, the writer of the put has long exposure to the stock but only on the downside. So the higher the dividends, the more he loses, because he's not getting more and more of the FCF of the stock he "owns." So, he needs to be paid a higher price to be compensated for this.
Hull puts out a good book which explains this. Jhoratio is correct.
Put and call strikes generally ignore dividend payments, unless the OCC rules otherwise. As a result, all the option or call holder cares about is the stock price on the day of the expiry.
Let's say that you own puts on The Illini Widget Company (IWC) at $55 that expire in August. The current stock price is $63. Looks like you're out of the money, and unless the price moves, your IWC puts will expire worthless.
Tonight, one of IWC's major factories burns down. It's insured and IWC decides that rather than to rebuild, they will just make a dividend payment of $15/share from the insurance proceeds that goes ex-div July 30th. The market for IWC is pretty boring meantime and the stock price hovers around $60-65. On July 30th, IWC's $15/share dividend goes ex-dive and the stock price is now $49. Your put now has an intrinsic value of $6/share whereas it had a $0 intrinsic value before the dividend.
I've shown you what happens in an extreme situation, but it works in smaller situations, too.
One other way to think about it is that for most black scholes purposes, we treat the dividend as a percentage rather than a dollar amount and reinvest the dividend in the stock. In other words, it's a return on the stock in the same way that interest is a return on dollars. This counteracts the interest rate. High interest rates make puts cheaper, because the guy selling you the put is shorting the stock and getting more interest on the proceeds to invest to maturity; likewise, high dividends make it more expensive for him to short the stock because he is required to pay "interest" or dividends to the stock lender he's borrowing from the short.
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