A record number of special dividends from some of the largest companies in the US were awarded last month, courtesy of the fiscal cliff. Here, former CBOE market maker Alex Mendoza details how special dividends impact option prices.

As traders across the world have begun to accept the reality that the stock market does not always rise by an average of 10% per year, they have begun to look for different ways to invest their money. One of these ways involves buying stocks that pay dividends. As the dreams of a 10% annual gift wane, they are replaced by a new landscape in which investors are willing to take on the risk of stock ownership in exchange for a dividend payout in the range of two to two-and-a-half percent per year! Of course, while most dividends are paid on a defined quarterly schedule, some dividends are paid on a more sporadic basis. Such dividends, typically paid “on a whim” are called special dividends, and they behave somewhat differently from the standard quarterly type.

What is a Special Dividend?
Unlike standard quarterly, or otherwise periodic dividends, a special dividend is one that is not part of the corporation’s dividend program. Therefore, a special dividend cannot be anticipated or assumed beyond the one-time occurrence. Because there is no assumed stream of payments with special dividends, future special dividends cannot be factored into standard option prices.

Contrary to the relatively small but consistent payment stream associated with regular dividends, special dividends tend to be larger one-time payments. As such, the Options Clearing Corporation (OCC) has developed a separate protocol to deal with such payments so that option traders are not adversely affected by the large change in the stock’s value due to the large payout.

How Are Options Affected by Special Dividend Payments?
There are many ways in which the OCC may adjust options in order to ensure investor safety. One of the more common ways to adjust options for a special dividend is to change the option strikes by the amount of the dividend. This can be a confusing concept for new options traders, so to illustrate, let’s take the case of Costco (COST), trading near $106 per share. COST issued a special dividend valued at $7.00 per share. The ex-dividend date was December 6, 2012. The following option chain shows front-month COST options on December 5—the day before the ex-dividend date.

COST Option Matrix Pre-Special Dividend

Click to Enlarge

Most dividend investors know that when a company pays out part of its value in the form of a cash dividend, it follows that the company’s per-share value must drop by the dividend amount. After all, the money to pay the dividend can’t come from thin air!

NEXT PAGE: What Happens to Your Options

Tickers Mentioned: Tickers: COST