Covered Calls with Dividend Stocks: What You Need to Know

Jesse Anderson

Published on October 17, 2022

As you learn more about covered calls, you will come across information about using dividend stocks to write covered calls. Much of the strategic opportunity – and risk –  lies in understanding the timing of dividends.  This post covers the basics of dividend timing and the ins and outs of using dividend stocks with covered calls.

As a refresher, a covered call is a type of options strategy that involves selling call options on a stock you already own. By selling the call option, you agree to provide the buyer with the right to purchase your stock at a specified price within a specific time.

The fact that you own the stock already is what “covers” the call – you aren’t exposed to the risk of having to go buy the stock if the buyer decides to exercise their option. Covered calls can be a way to generate premium income from stocks that are unlikely to see much price movement in the near future.

You can read more about the basics of setting up a covered call strategy in our post Start Your Own Covered Call Strategy.

Writing covered calls on dividend stocks is a popular strategy since  it increases the shareholder’s income above just the dividend yield. Over the last few decades, the dividend yield on the S&P 500 has been around 2%.  For investors needing an income boost, layering covered calls on top of dividend stocks can greatly improve your annual income.
While the strategy seems logical; the challenge is that markets tend to be efficient and price the options ahead in anticipation of the dividend payment.Understanding the impact of dividend dates and option pricing is critical to a successful strategy.

To understand this strategy better, let’s review the timing of dividends.

Important Dates for Dividend Stock Investors

As you know, dividend stocks pay regular dividends to investors who own those stocks.

Dividend stocks from established companies are relatively stable and less likely to experience sharp price swings. Their low volatility makes them an appealing choice for investors looking for income and stability.

For investors interested in buying dividend stocks, understanding dividend dates are essential. Here are the basic terms and what they mean:

• Declaration date:  the declaration date is the day the board of directors declares a dividend.
• Ex-dividend date: Any new investors who purchases the stock on or after the ex-dividend date will not be eligible to receive the upcoming dividend payment. The term ex-dividend refers to a stock trading without the value of the next dividend payment.
• Record date:  For most companies, the record date falls two business days after the ex-dividend date.
• Payment date: the date when shareholders receive payment. The payment date is typically several weeks after the record date.

Knowing the timing of dividends helps investors plan to ensure they are eligible to receive upcoming dividend payments.

How Do Dividends Impact Option Pricing?

Dividends impact the price of call and put options. As shown above, when a company declares and pays a dividend, shareholders must purchase shares before the ex-dividend date to receive the upcoming dividend payment. All else being equal, the dividend reduces the value of the underlying stock by the dividend amount on  the ex-dividend date.

The reduction in value also affects call and put option premiums since they are based on the underlying stock price. At the money call options will generally decrease by an amount equal to the dividend, while at the money put prices will increase by an amount equal to the dividend.  You can read more about an option’s delta to better understand how the movement of a stock’s price impacts the option prices.

Before a dividend payment, the cash is on the company’s balance sheet.  As a result, it is also factored into the stock’s market price.  On the ex-dividend date, the funds move from an asset on the balance sheet to a liability owed to its shareholders.  Since most companies have a consistent dividend payment, the market price of the option prices factor in this cash flow.

It is important to consider how dividends may impact your option strategies before making trades.  Comparing put and call prices on the same option chain near a dividend payment can look very odd without considering the dividend payment.

Dividends and Options Assignment Risk

Dividend payments are one of the most common reasons for an early assignment with covered calls.  The option buyer can exercise the option any time prior to expiration.  If the call is currently in-the-money but the dividend payment will cause the market price to drop below the strike price, you are at a high risk of an early assignment.

Remember you must own the shares prior to the ex-dividend date to receive the payment.  When the option buyer exercies their option, you are forced to sell your shares at the strike price.  If they do this before the ex-dividend date, you will be forced to sell your shares and miss out on the dividend payment.  Closing your covered call prior to the ex-date or verifying the strike is well out-of-the-money is the best way to avoid an early exercise.

You can do a few things to reduce the risk of being assigned early on an option trade.

• First, ensure you know if the underlying security pays a dividend and when that dividend will start trading ex-dividend.
• Deep in-the-money or out-of-the-money covered calls are less impacted by dividend payments
• Avoid selling options on stocks or ETFs with an expriation near the ex-dividend date

Pros and Cons of Covered Calls with Dividend Stocks

Experts don’t always agree on the wisdom of writing calls on stocks with high dividend yields. Some experienced options traders endorse this strategy, believing it makes sense to generate the maximum possible yield from a portfolio at all times.

Others argue that the risk of the stock being “called away” is not worth the small premiums possible from writing calls on a stock with a high dividend yield.

The blue-chip stocks with high dividends are usually in sectors like telecoms, financials, and utilities. This is because the high dividends lead to less volatility in stock prices, which in turn means that option premiums are lower. With optionDash’s advanced screening criteria, you can set both a minimum and maximum dividend yield to find stocks meeting your specific needs.

The Bottom Line

This blog post discussed covered calls and how they work with dividend-paying stocks. We also outlined some of the risks associated with using this strategy. Stock screeners like OptionDash offer valuable tools to save time in your analysis. If you’re considering this strategy and would like some help, reach out for a conversation with our partners at Snider Advisors. They also have a library of free resources to take a deeper dive.