Options traders often abstract away the link between the puts and calls that they trade and their respective underlying stocks. This usually works well – traders can make plays on volatility, the Greeks, time decay, and a variety of other things that have nothing to do with the underlying security.
However, it’s important to keep in mind that, ultimately, options are derivatives, and they’re still affected by the nuances of the stocks that they represent.
If this is too vague for you, let me solidify it with an example.
A few months ago I sold a bear call spread on SPY, which is the ETF that tracks the S&P 500. Though I should have thought this trade out a bit more (since it was against the trend), I thought that the strike price was far enough from the stock price that there was a large enough safety margin. The Thursday before the options that I sold were set to expire, SPY closed in the money by about 12 cents. Surprisingly, the calls that I sold had been exercised, and that Friday, I logged in to my account to see myself short several thousand shares of the Spiders. Eventually I bought back the shares that had been sold short to close out my position. Ultimately, I had made a profit on the entire trade, at least that’s what I thought at the time.
What I didn’t realize was that the reason those calls had been exercised was that SPY was paying a dividend, and by exercising early, the buyer of those calls owned the shares on the day that was required in order to receive the dividend. Unfortunately for me, that day just happened to be the day before my options expired, and also unfortunately for me, the strike price was close enough to the stock price that it made it profitable for the buyer to exercise his calls.
By exercising his shares, the buyer of those calls forced me to sell several thousand shares of SPY, and in doing so, obligated me to not only sell him those shares, but also pay him the dividend that was paid out on those shares. That dividend was collected from the cash balance of my account last month and was paid to the buyer of those calls. Ultimately, the payment exceeded the profit I received from the original credit spread, turning what I thought was a profitable trade into a small loss.
The key lesson here (other than to always remember that the trend is your friend), is to always be aware of dividend announcements on any stocks for which you sell calls, and also to always choose a strike price that is so far out of the money that the likelihood of the stock surpassing it is almost negligible.
Next time, I won’t make the same mistake, and now that you’ve read this, hopefully you won’t either.
