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Hey everyone, Kirk here again at Option Alpha and welcome back to the daily call. On today's daily call, I want to talk about a really hot topic which is dividend assignment risk for short call options. This is a topic that we have videos and training on, but again, I wanted to get another avenue of teaching this out, so that people understood how to effectively navigate this scenario because I think it freaks a lot of people out. What usually happens is the brokers would send you a notice or an alert that says, “Hey. You have a short call option that’s at risk of assignment.” People basically throw their hands up and say, “What the heck is going on?” I usually get these emails which is maybe why you’re even getting this podcast link or maybe I sent you a link to this podcast because what people do is they throw their hands up and they’re like, “What the heck is going on? I’m going to be assigned. I don’t have the capital to handle it.” Here’s what happens and I want to walk through this process, so you understand it. Please, please, please, if you're listening to this right now, take the time to understand this. This is one of those concepts where if you understand this concept right now and just take maybe five or 10 minutes, however long it takes me to explain this. If you understand this concept now, it saves you so much headaches in the future. Just really hone in on this and try to understand this ant it’ll set you up for the rest of your life. Dividend assignment obviously happens when a stock or an ETF has a dividend payment coming up, so if they have quarterly, if they have monthly dividends, semi-annual, annual dividends. It’s only going to happen and you’re only going to be faced with this scenario if you have an underlying that you’re trading and it has a dividend payment coming up. In particular, it's only going to affect your short call options. Again, it’s only going to affect your short call options. It will never effect any put options. It will never affect any long call options because you’re a long call option buyer and you have the choice to exercise or not. Again, it only affects short call options and in particular, (now we’re starting to get even more granular here) it's only going to affect short call options that are in the money, meaning that the stock is trading higher than your short call strikes. Let’s say the stock is trading at $100, you sold a call option at $95 and the stock rallied up to $100, so now your option is in the money. That’s the one that’s going to be at risk of assignment. You can see there’s already a very, very small window here where this impacts people, but it does and we have to understand it. We have the short call option that’s in the money, the stock is about to pay a dividend and now, the option buyer to your short call option… The call option buyer has the choice to basically assign you and force you to sell the stock, so that he can buy the stock and collect the dividend. That’s basically what happens. If that is the case, then we have to understand the logic behind why they bought the call option in the first place and what the goal was in doing that. I think a lot of this comes down to understanding what the position is of the long call option buyer and then why would they want to go through this entire process, why would they want to deal with the stock now when they didn’t want to deal with the stock to begin with. That's really the first I guess roadblock that we have to cross in this example. If the person that was buying the call option didn’t have any other thought processes of wanted to control risk in any way, they would’ve just bought the stock to begin with and we wouldn’t have had this conversation. But they bought a long call option because they wanted to do two things with this position. One, they wanted to reduce their downside risk. If they bought a long call option, they wanted to reduce their downside risk at anything below that strike price. If you look at a payoff diagram of a long call option, it has reduced risk which means that you don't lose any more money if the stock goes below your short strike. In our case, in our example that we’re talking about right now, the strike price on the option contract is 95, so the long call option buyer doesn't lose any money if the stock is below 95. They lose their premium that they pay, but they don’t lose any more money beyond that. It’s flat. The second thing that they wanted to do is they wanted to maintain all of the upside potential. This is what usually sucks a lot of people on a long call option buying, is that they have limited downside risk, not including their premium that they paid and they have all this upside potential. If the stock rallies, they participate in everything above 95. The stock goes to 100 or 120 or 200, they participate in all of that. That's what they wanted to do. Again, they didn't choose to do stock initially. With that context in mind that they wanted to have no downside risk below their strike price of 95 and all upside potential, you have to then assume… It's best to assume that that option buyer, if they were to go through this entire assignment process, exercise their contract, assign you, buy stock from you, your short stock, they want to go through this entire process that they would want to get back to the same general position that they started to begin with. They wouldn't do this unless they have ability to get back to the same general position that they started with which is reduce downside risk below the short strike and all upside potential. Hopefully that makes sense. If it doesn't, rewind it a little bit just so we get the concept really down. Now, the stock has a dividend payment coming up and let’s say that that dividend payment just for the sake of argument is going to be $.50. It’s going to be $.50, is going to be the dividend payment, so every share will get $.50 or basically, if you have 100 shares, you would've gotten $50 in dividend payment, whatever the case is. Now, here's how you associate that risk of assignment. What you’re going to do is you’re going to look on the pricing table for your short call option. Your short call option again is at a 95 strike. The stock is trading at $100. You’re going to look across the pricing table and see what the 95 put option is trading for. Again, you’re going to look across the pricing table and you’re going to look at the same strike price, but on the put side and see what the 95 put option is trading for. In this case, let's say that the 95 put option is trading for $.30. Right now, if you wanted to, you could go out and buy a put option for $.30. The corresponding put option to your call is trading for $.30. In this scenario… I’ll walk through why this is in a second. But in this scenario, your short call option would be at risk of assignment and the reason that it's at risk of assignment is because if the long call option buyer were to exercise his position, if he were to exercise his call option, he would be assigned shares or would be long shares at 95. That’s what he wanted initially. That’s what a call option does. He’s long shares at $95, the stock is trading at $100, but irrespective of everything else at this point in the process, he also has all of the downside risk of being long stock at $95. It would just be like you bought stock at $95 and you have all the same downside risk. Now remember, that’s not his initial intention. The initial intention was (because he did the long call option) to have no risk below $95. If you think about that, what he would want to do to convert that position into a similar long call option type position, but now with long stock is he would buy a put option at a 95 strike. Hopefully a lot of light bulbs just went off in your head. There's no difference in the payoff diagram between a long call option and long stock with a put option at the same strike. If he was long stock at 95 and also bought a put option at a 95 strike, he would effectively be in the same payoff diagram that he was in with a long call option. It’s the same payoff diagram. If the stock goes down in value, it is protected by the long put option he bought at the 95 strike. Hopefully that concept just makes sense, like why he would go through this assignment process. Now, here's where the pricing comes into play. Remember, if he is going to assign or exercise his contract, collect the stock or basically buy the stock effectively at $95, he would then be eligible to collect the dividend payment of $.50 per share. If he was to collect the dividend payment of $.50 per share, he could use part of that dividend payment to buy that put option contract. He’s basically financing that put option contract which again was $.30 in this example. He’s financing that put option contract with the dividend that he collected. He collected a $.50 dividend, the put option is less than the value of the dividend, so the put option is $.30, he pays $.30, gets his protection back in place basically, reestablishes his protection and he still has $.20 left over as additional profit. Now, he’s long stock, he has a long put option at 95, effectively, the same position that he had before payoff diagram wise, but he’s also pocketed an extra $.20 because the dividend was $.50 and the long put option was $.30. Does this make sense? Here’s the underlying crux of how you can evaluate this and then we’ll go through an example of why he wouldn’t go through this assignment process. If you look at your short call option, if the corresponding put option is less than the value of the dividend being paid, you are at risk of assignment. I’ll say it again. If the corresponding put option at the same strike to your short call is less than the dividend being paid, you are at risk of assignment because the option buyer to your call option could exercise his contract, be long stock, collect the dividend and pay to reestablish his protection via the long put option and still have money left over. And so, theoretically, a smart investor would do that all day, all night. It's the same position, but he pocketed some extra money from the dividend. If that's the case, then here's the other example that you need to understand or here's the other side of it. If the put option to your corresponding short call is more than the dividend being paid, you are not at risk of assignment. I’ll say it again. If the put option that is corresponding to your short call at the same strike is worth more than the dividend being paid, you are not at risk of assignment where there’s a very low chance that you could be assigned. Why is this? Let's say now as a new example that the corresponding 95 put option to your short 95 call is trading for $.70. Remember, the dividend being paid is $.50, but that put option is $.70. If he was a logical investor which they’re always like… If they’re logical and most cases they are… They really are once they go through this process. If it’s a logical investor, if he were to exercise his contracts and go long stock at 95, collect the dividend of $.50, he’d have to pay out more than $.50 to buy that put option at 95 and reestablish his risk protection. Basically, he’d be in a better position. He would lose less money if he just didn't exercise his contract. Just forego the dividend, don't collect the dividend, don't deal with the stock, don't deal with buying the put option because it's cheaper not to do anything in that case. The long put option protection is more expensive than the dividend that he would be paid, so he’s not going to do it. He’s not going to assign the contracts. He’s not going to exercise his position because it's not worth it for him financially to pay money to get back into the same position, if that makes sense. The key here with dividend call assignment or dividend assignment risk for these short call options is the value of the dividend and how that relates to the corresponding put option. Just to recap it one more time. If the corresponding put option is worth less than the dividend being paid, you're at risk of assignment. If the corresponding put option is worth more than the dividend being paid, you're not at risk of assignment. I know it went a little bit longer today on this daily call, but again, it was so, so important that you understand this concept. Please go back and re-listen to it five times, ten times if you need to. If you don’t understand it right now, obviously let us know. Ask us questions. It's a really important concept. Again, these brokers, they have to send out these assignment risks just to let you know, but that doesn't mean that it's going to be assigned. It just means that you have a short call and a dividend is coming up. Basically i.e. check your position, make sure that you're okay, whatever the case is. Hopefully it helps out. As always, if you have any questions or comments, let us know. Until next time, happy trading!