Don't Get Stuck Paying the Dividend on Your Short Trade

 

If you're writing options on dividend-paying equities, you need to understand the risks of early assignment

Many trading strategies, such as covered-call or spread trading, involve options writing (selling), where the primary risks are market movement and volatility. But there’s another risk if you happen to be writing options on dividend-paying equities like SPY ETFs: early assignment.

In a rush? Watch the video to learn about the risk of early assignment and the differences between American
and European style options.

All options are either American or European style, which dictates when the option can be exercised or assigned. (It has nothing to do with geography.) All equity (single-stock) and ETF options are American style. American style options can be exercised or assigned at any point in time on or before expiration. SPY (ETF) options are American style, meaning the option owner may choose to exercise ahead of expiration. For example, this often occurs in advance of the quarterly ex-dividend date.

The ex-dividend date is the first trading day when a dividend-paying stock or ETF’s price drops to reflect its next dividend payment. So, if an ETF pays a $0.25 dividend, the price may decline by that amount prior to trading on the ex-dividend date, barring other market factors.

If an option is in the money going into the ex-dividend date and the dividend exceeds the remaining time value of the option, the call owner likely has economic incentive to exercise their options early. This leaves the seller in the position of having to deliver the shares as well as the dividend.

Managing Early-Assignment Risk

An alternative is to try trading Mini-SPX Index options, which go by the ticker XSPSM. They also track the S&P 500® and they have the same notional size as SPY options. But Mini-SPX options are European style, which means they can only be exercised/assigned at expiration. European style options eliminate the uncertainty of early exercise, which many traders prefer. Also, index options do not pay a dividend. 

Mini-SPX index options have a number of other advantages that traders appreciate, including cash settlement, which can help reduce risk of unexpected post-settlement market moves. Learn more about cash-settled versus share-settled options.