Using Traded Options to Gauge the Safety of Dividend Payments
InvestorEducation / Dividends Dec 05, 2008 - 07:40 AM GMT
Nilus Mattive writes: Over the past few weeks, I've told you about some dividend bright spots — companies and sectors where payments continue to rise despite the weakening economy.
But I've also told you that many dividends have been cut or suspended. And many more are likely in jeopardy right now, especially as the “now-official” recession deepens.
So the natural question becomes, “How safe are your dividends?”
As I recently showed my Dividend Superstars subscribers, there are plenty of ways to determine the health of a company's future payments — including fundamental measures like cash flows, profits, and payout ratios.
And there is also an interesting way to see what a group of very savvy investors think about a company's future dividends.
It doesn't get any play in mainstream investing columns, but it's a very cool little analysis technique that you can do relatively quickly. That's why I want to tell you about it today …
What Options Investors Can Teach You About Dividends
Options contracts give investors the right to buy (call options) or sell (put options) a given security at a predetermined price (the strike price). Just like insurance policies, these contracts also have predetermined timeframes.
Institutions and other professional investors use options to hedge positions in their portfolios and as pure profit plays. So do savvy individual investors.
There are a lot of variables that factor into an options' price — especially the movements of the underlying security and the time remaining on the contract. Complicated mathematical formulas have been created to help determine the fair value of an option at any given time.
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| Options traders use complicated formulas to determine fair prices. |
Collectively, a lot of analysis is working behind the scenes to make sure options prices reflect every possible outcome. And, yes, even dividends factor into the equation!
So by comparing similar puts and calls for the same underlying stock — known as put-call parity — you can actually see whether options investors think the company is going to pay a dividend (either regular or special) during a specific timeframe.
Here's how it works:
Step #1. Pick a put and a call for the same stock, making sure they have the same strike prices and expiration dates.
Step #2. Subtract the put's value from the call's value.
Step #3. Take the result and add it to the strike price.
Step #4. Now subtract that number from the current share price.
What you're left with is roughly the anticipated dividend payments over the life of those options.
Here's a real-world example:
A few months ago, IBM's stock was trading at 92.51 a share. A January 2009 call with a strike of 100 was going for 4.50. And the same put was going for 13.30.
So, subtracting the put from the call would leave you with -8.8.
Adding that to the strike price of 100 would give you 91.2.
And subtracting that from the current share price of 92.51 leaves you with 1.31.
In other words, the options market was expecting $1.31 in dividends from IBM through January.
Now, by no means is this an exact science. Plenty of other market factors can contribute to the 1.31 discrepancy, too. But when the difference is relatively large between similar puts and calls on the same dividend stock, you can safely assume that options investors are expecting some kind of payment.
And you can take your analysis one step further by looking at a given company's recent dividend history to determine if the number is in line with regular quarterly payments or if it might reflect a special dividend as well.
The best part is that you no longer need any kind of fancy subscription or trading platform to get options pricing.
Major financial websites like Yahoo Finance have all the information you'll need to do this simple put-call parity analysis.
From the main page, pull up a quote on your favorite stock, and then click on “options” on the left-hand navigation bar. You'll see a whole list of options prices.
From there, all you have to do it match up a pair of puts and calls and follow the math above. It's that easy! Just remember to use options that have the same strike price and expiration dates.
Best wishes,
Nilus
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