How Index Options Can Help Traders Mitigate Dividend Risk

October 07, 2024 at 08:30 AM EDT

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By Cboe, Benzinga

The usage of options products is on the rise. According to the Options Clearing Corporation (OCC), the world's largest equity derivatives clearing organization, the total options volume for August 2024 was 1,060,360,119, an increase of 4.1 from the previous year. Year to date, average daily volume has been 47,362,479, an increase of 6.7% from the previous year. Furthermore, the average daily volume in 2023 was more than twice that in 2019.

The increased options usage indicates investors' growing familiarity and confidence in incorporating these products into their trading strategies. However, some aspects of options trading are worth highlighting, as some investors may be unaware of a risk they should consider.

Consider The Effect Of Dividends On Your Option Trades

For investors utilizing options, particularly those writing options on dividend-paying equities, a dividend payment can impact one’s trading strategy. Dividends provide a reliable way to generate income from equity investments. However, options holders are not eligible to receive regular quarterly dividend payments, no matter when they acquire their options. Additionally, unlike stock or ETF prices, the prices of options contracts are not reduced on ex-dividend dates. This can pose a problem for anyone who has sold an options contract without factoring in the effect of dividends. Why? Because it increases the risk of being assigned on the contract.

Options Assignment Risk And The Impact Of Dividends

Options assignment risk refers to the possibility that the seller of an options contract may be required to fulfill the terms of the contract before its expiration date. In the case of a call option, the seller may be required to sell the underlying asset at the strike price if the option is exercised by the buyer. For a put option, the seller may have to buy the underlying asset from the option holder.

The risk arises because American-style options can be exercised early, often due to specific events like dividend payments. For example, if an underlying stock is about to pay a dividend, holders of call options may choose to exercise their option early to capture the dividend. This can result in the option writer (i.e., the seller) being unexpectedly assigned, forcing them to sell the stock at the strike price, potentially at a loss. Given that a dividend-paying stock or ETF’s price may decline by the dividend amount prior to trading on the ex-dividend date – barring other market factors – the option writer may even find themselves effectively paying the dividend, as well.

Understanding assignment risk is crucial for investors utilizing options, especially those who sell options, as it can affect their strategies and outcomes.

Mitigating Options Assignment Risk

A comprehensive way for investors utilizing options to mitigate assignment risk is to use European-style options, which, unlike American-style options, can only be exercised at the expiration date, not before.

Cboe Global Markets (CBOE: CBOE) offers European-style index options via their XSP Index options. These options contracts track the S&P 500 Index, but they represent a fraction of the size of standard SPX options. Specifically, XSP options are one-tenth the size of standard SPX options, making them more accessible for smaller investors or those looking to take smaller positions in the S&P 500 market. Furthermore, XSP options are cash-settled, in that, upon expiration, if the option is in-the-money, the settlement is made in cash based on the difference between the strike price and the index's final settlement value rather than requiring the delivery of the underlying index components.

XSP index options allow investors to gain exposure to the broader U.S. equity market and mitigate option assignment risk, making them appealing to options traders seeking more control over their trades.

Learning More About Options

Cboe Global Markets has The Options Institute, an educational platform that allows both beginners to options trading and professional traders a forum to familiarize themselves with foundational knowledge on options or learn new developments taking place within the investment derivatives landscape.

The Options Institute provides comprehensive courses and tools, equipping investors with the knowledge needed to navigate the complexities of options trading effectively. It is important to remember that responsible options trading is based on defining an investment objective and using analysis and informed decision-making to determine the most appropriate trading strategy, not emotions. Understanding how options work and the associated risks, just like any other financial asset, is paramount.

Options can be among the best financial tools for enhancing and protecting one’s portfolio or even speculating about current events. As individuals increase their knowledge of these products, they may continue to see growth in their usage year over year.

Featured photo by Tyler Prahm on Unsplash.

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