How Does Dividend And Interest Rates Affect The Stock Options?

The core ideas are simple, despite the fact that the math underlying options-pricing models may look complex. The price of the underlying stock, volatility, time, dividends, and interest rates are the factors used to determine a stock option's fair value. Since they have the biggest impact on option prices, the first three justifiably receive the most attention. But it's also critical to know how interest rates and dividends impact stock option prices, particularly when determining whether to exercise options early.

 

•    Both interest rates and dividends are factors in options pricing models, and they have differing effects on calls and puts.

 

•    Increases in interest rates will enhance the value of call options, which have positive rho, while decrease the value of puts, which have negative rho.

 

•    When a stock goes ex-dividend, call prices fall and put prices rise since only stockholders receive dividend payments, not option holders.

 

The Black-Scholes model, the first option pricing model, was created to assess European options, which do not allow for early exercise. Thus, neither the timing nor the value of early execution of an option were discussed by Black and Scholes. Although there isn't much of a difference in how they are traded in practice, the fact that an option can be exercised at any time should theoretically increase the value of an American option over a comparable European option.

 

In order to appropriately price American choices, many models were created. The majority of them are enhanced Black-Scholes models that have been modified to account for dividends and the potential for early exercise. To fully recognize the distinction, you must first comprehend when an option should be exercised early.

 

In a nutshell, when an option's theoretical value is at parity and its delta is exactly 100, the option should be exercised early. This may sound difficult, but we'll use an example to demonstrate when it happens when we go over the impact interest rates and dividends have on option pricing. Let's start by taking a closer look at how interest rates affect option prices and how they can influence whether you should exercise a put option early.

 

Rho gauges how responsive the price of an option is, to changes in interest rates. Call premiums will rise along with interest rates, but put premiums will fall. Therefore, puts have a negative rho while calls have a positive rho. You must consider the impact of interest rates when contrasting an option position with merely holding the stock to fully grasp why. The call buyer is willing to pay more for the option when rates are relatively high since they can invest the difference in the capital necessary between the two positions. This is because buying a call option is significantly less expensive than purchasing 100 shares of the stock.

 

Interest rates have little impact on option prices when they are progressively declining to a point where the federal funds target is close to 1.0% and short-term interest rates available to individuals are close to 0.75% to 2.0% (like in late 2003). Using a risk-free interest rate, such as U.S. Treasury rates, all of the top option analysis models factor interest rates into their calculations.

 

When deciding whether or not to exercise a put option early, interest rates are the key consideration. Anytime the interest that may be made on the money generated by the selling of the shares at the strike price is sufficient, a stock put option becomes a candidate for early exercise. Since everyone has different opportunity costs, it might be challenging to pinpoint exactly when this occurs, but it does imply that early activation of a stock put option can be optimal at any moment, providing the interest received rises to a significant level.

 

The impact of payouts on early exercise is more obvious. Cash dividends impact option pricing by impacting the value of the underlying stock. High cash dividends imply lower call premiums and higher put premiums because the stock price is anticipated to fall by the dividend amount on the ex-dividend date.

 

Option prices account for dividends that will be paid in the weeks and months prior to when they are declared, although the stock price itself often experiences a single adjustment by the dividend amount. While determining the theoretical price of an option and forecasting your likely gain and loss when charting a position, the dividends paid should be taken into consideration. This also holds true for stock indices. When determining the fair value of an index option, dividends paid by all stocks included in that index should be considered (adjusted for each stock's weight in the index).

 

Both buyers and sellers of call options should think about the effect of dividends because they are important in evaluating when it is best to execute a stock call option early. Owners of call options may exercise in-the-money options early to take advantage of the cash dividend since it is paid to everyone who owned the stock as of the ex-dividend date. Only if the stock is anticipated to pay a dividend before the option's expiration date does early execution make sense for a call option.

 

In the past, the best time to exercise an option was the day before the stock's ex-dividend date. However, due to changes in dividend tax legislation, it can be two days before the call's exerciser intends to keep the shares for the required 60 days to benefit from the lower dividend tax rate. Let's look at an illustration to discover why this is the case (ignoring the tax implications since it changes the timing only).

 

Consider that you have a call option with a 90 strike price that expires in two weeks. The stock is now trading at $100, and tomorrow's dividend payment is anticipated to be $2. The call option should have a fair value of 10 and a delta of 1 because it is heavily in the money. Therefore, the stock and the option are similar in many ways. There are three options available to you:

 

1.    Exercise the option early, 

 

2.    do nothing (keep the option), or

 

3.    Purchase 100 shares of stock and then sell the option.

 

Which option among these is the best? Your delta position will be maintained if you keep the option open. However, after deducting the $2 dividend from its price, the stock will open ex-dividend at 98 tomorrow. The option will open at a fair value of 8, which is the new parity price, because it is at parity, and you will lose two points ($200) on the position.

 

Early exercise of the option locks in the 10 value points. You lose $2 per share when the stock opens two points lower on ex-dividend day, but since you now own the equity, you also get the $2 dividend.

 

You would be better off exercising the option than retaining it because the $2 loss in stock price is more than offset by the $2 dividend you got. You avoid suffering a two-point loss, not because you made any more profit. In order to break even, you must exercise the option quickly.

 

Consider the third alternative, which involves selling the option and purchasing stock. Given that you are substituting stock for the option in both instances, this appears to be quite similar to early exercise. The cost of the option will affect your choice. Since we stated that the option is trading at parity in this instance (10), early exercise of the option and the sale of the option in favor of stock purchase would have no financial impact.

 

Options don't always trade exactly at parity though. Let's imagine the price of your 90 call option is more than parity, let's say $11. You still receive the $2 dividend and finish up with shares worth $98 if you sell the option and buy the stock, but you also end up with an extra $1 that you would not have received if you had exercised the call.

 

Alternately, you might choose to execute the option early if it is trading for less than parity, like $9. By doing this, you guarantee that you will lock in the $2 dividend as well as 10 points (as opposed to 9 if you had sold the call). Only when the option is trading at or below parity and the company is set to go ex-dividend the next day does it make sense to exercise a call option early.

 

Although dividends and interest rates are not the main determinants of an option's price, the trader in options should nevertheless be aware of their effects. The fact that many of the available option analysis tools utilize a basic Black Scholes model and disregard interest rates and dividends is actually their main flaw. Lack of early exercise adjustment can have a significant impact because it can make an option appear to be 15% undervalued.

 

Never forget that it makes sense to employ the most precise instruments available when you are competing in the options market against other investors and experienced market makers.