If it seems that a stock is overvalued or its premium undervalued, one event that would account for this is an upcoming ex-dividend date, writes Alan Ellman of TheBlueCollarInvestor.com.
When studying option trading basics, we learn the equation for option premium value is:
Premium = time value + intrinsic value
If the strike price is at- or out-of-the-money, the premium is all time value. Another basic principle is that time value decreases as we approach expiration Friday. Unless the strike price is deep, deep in-the-money, we would expect a decent amount of time value if the contract has three weeks remaining until expiration Friday.
Real Life Example
Recently a BCI member contacted me about such a situation when there was seemingly virtually no time value remaining for a slightly in-the-money strike. Let’s examine the trade:
Mid-March: RTN was purchased and the April $57.50 call sold
March 28: RTN trading @ $58.59, $1.29 above the strike price
The option chain showed a bid-ask spread of $1.19-$1.30, with apparently no time value. Here is that options chain:
RTN options chain: March 28
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to Enlarge
It appears that either the stock is overvalued or the premium is undervalued. One event that would account for this is an upcoming ex-dividend date. Let’s check to see the possible dividend information for this equity:
Dividend information for RTN
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to Enlarge
The dividend ex-date is important because that is the date the owner must hold the rights to the stock to be eligible for the $0.55 dividend. April 1 happens to be the next trading day after March 28 because of Good Friday and then the weekend. Now, when a dividend is distributed, the value of the stock decreases by the amount of the dividend, $0.55 in this case. Therefore, the $1.25 option premium for the $57.50 strike was based on a share value of $58.24 ($58.79 – $0.55).
If your head is not yet spinning, let me take this one step further:
Time value on an underlying valued @ $58.24 = $1.25 – $0.74 = $0.51
Since the market is evaluating RTN @ $58.24, the $57.50 strike is $0.74 in-the-money, leaving $0.51 of time value or about 1% for the three weeks remaining. The downside protection of that 1% is $0.74/$58.24 or 1.3%. This makes a lot more sense than no time value remaining with three weeks until expiration.
Conclusion
Just prior to the ex-dividend date, the options market will value equities based on the current market value minus the dividend about to be distributed. When an options premium does not make sense based on our education and experience, we must look for explanations before making trading decisions.
By Alan Ellman of TheBlueCollarInvestor.com
