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 XSP℠. Like SPX, they also track the S&P 500® but they have the same notional size as SPY options. 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. Mini Russell 2000 Index Options, trade under the ticker MRUT and are very similar, read more about them here. 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 here.
Recommended Reading
How Taxing Is Your Options Trade?
Why You Should Worry About Share Settlement When Trading S&P 500 ETF Options
Cboe Mini-SPX (XSP) is an index option product designed to track the S&P 500. At 1/10th the size of the standard SPX options contract, XSP is the same notional size as S&P 500 ETF options, but with the added benefits of:
- Cash settlement
- No early exercise
- May qualify for 60/40 blended tax treatment
*Under section 1256 of the Tax Code, profit and loss on transactions in certain exchange-traded options, including XSP, are entitled to be taxed at a rate equal to 60% long-term and 40% short-term capital gain or loss, provided that the investor involved and the strategy employed satisfy the criteria of the Tax Code. Investors should consult with their tax advisors to determine how the profit and loss on any particular option strategy will be taxed. Tax laws and regulations change from time to time and may be subject to varying interpretations.
The information in this article is provided for general education and information purposes only. No statement(s) within this article should be construed as a recommendation to buy or sell a security or to provide investment advice. Supporting documentation for any claims, comparisons, statistics or other technical data in this article is available by contacting Cboe Global Markets at cboe.com/contact.
XSP is a service mark of Cboe Exchange, Inc. All other trademarks and service marks are property of their respective owners. © 2019 Cboe Exchange, Inc. All Rights Reserved.