The term "dividend" simply refers to a payment that rewards the owners’ of a company with some of its profits. Each owner can claim a certain share in that company and hence the reason why these people are commonly known as shareholders.
Profitable companies can do one of two things with their earnings. For one, they can retain the money made and reinvest it to grow the business. In doing so the aim is to increase the bottom line of the business and make it more profitable. This is expected to be reflected in a higher share price. Businesses that reinvest their profits into their own business can be classified as growth companies.
Technology and pharmaceutical companies require expansive research and development teams to maintain cutting edge technology in the products provided. With resource based companies the amount of resources they have tenancy over is a finite amount and therefore they need to invest their earnings into expanding the geographical presence of their operations. It is for these reasons technology, pharmaceutical and resource companies are renowned for paying little to no dividends. These businesses focus on reinvesting in their core operations.
A second option a profitable business has is to return some of the profits to its owners, the shareholders. Investors in companies that pay regular large dividends as a percentage of the share price are known as income investors. This is because a solid income in the form of a dividend is consistently paid year on year by the company. Many people today who bought shares decades ago with large dividends would use these dividend payments to help fund their retirement. The well established finance and industrial companies fall into this category.
A term you may have heard of before is "dividend yield." The dividend yield is calculated by dividing the share price by the annualised dividend amount. For example, company AAA trading at $20 paying two $0.50 dividends will have a yield of 5%. One of the useful pieces of information this figures tells longer-term investors is how long it will take for the dividend to pay for the shares. In the example provided it would take 20 years ($20/$1) to pay for the cost of the share. Once again I have oversimplified this process because the compounding effect of inflation needs to be considered. This is where the discounted cash flow [DCF] model can be applied. This is something used by fund managers on a daily basis and beyond the score of this article.
Traders new to the options arena quite often think an easy way to make money is to trade a bearish strategy on a company about to pay the dividend. This is known as going ex-dividend. Unfortunately making money in the markets is not so simple. The Black-Scholes Option Pricing Model has a component for dividends resulting in the dividend being factored into the option price.
Following on from the example used, above let’s assume AAA goes ex-dividend tomorrow. The share is trading at $20 and a put options with a $20 strike price is trading at $2.00. In theory AAA should open at $19.50 tomorrow as the $0.50 dividend will be removed from the company’s books. The option price then in theory will remain close to $2.00 (a slight decrease due to time decay). Figure 1, below, tabulates this information.
Table 1: Theoretical values of AAA upon ex-dividend
In reality the share price could open above or below this price. Expecting the share to open at $19.50 is the same as expecting the open price of any share to exactly match the previous day’s close. The movement of overseas markets, government announcements or a competitor’s announcement are just some events that could influence a share price to open at a different price to the previous day’s close.
There are traders who do have systems that are employed when a company is about to go ex-dividend. A common belief is that shares sell off after a dividend is paid. This is because the share owners wait to sell their shares until after the dividend date. If enough people trade this way I guess it will be a self fulfilling prophecy!
The final area I will cover in this article on dividends has to do with a term used to describe the major market indices. It is "accumulation index." How does this differ from the indices we are all familiar with, such as the ASX200, DJ30 and S&P500? The accumulation index is the basic index (e.g. ASX200) plus any dividend payments factored in. This allows researchers to compare the performance of share market sectors and indices against other assets such as property and fixed interest.
I hope this article has provided you with a better understanding of dividends and how they fit into both the share market and options market. As your education grows as an options trader, you will learn that a dividend payment has no effect on the value of an open positions value. Implied volatility, share price movement, time decay and the current interest rate will.
Make it happen!
Guy Halpin
Senior Writer & Options Strategist
Optionetics.com.au ~ Your Options Education Site
