Question

A trader has a call option contract to sell 100 shares of a stock for a strike price of $50. What is the effect on the terms of the contract of the following events?

(a) A $5 dividend being paid
(b) A 5-for-4 stock split
(c) A 10% stock dividend being paid.

Answer 1

Cash dividends have an effect on choice costs through their effect at the underlying stock charge. Because the inventory charge is anticipated to drop through the quantity of the dividend on the ex-dividend date, high cash dividends imply decrease call premiums and higher put premiums.

a)

When a $ 5 dividend being paid on a share which were priced before $50 then its price shall fall to $45 (50-5)

hence option price shall also get down by $5 per share which will result in a loss of $500 (100 shares * 5 per share)..

b)

When a 5 for 4 stock split will happen on a share which was priced before $50 then its price will be reduced (50*4/5) $ 40 per share.

so the loss for the call option holder will be $ 1000 ($ 10 per share * 100 shares).

c)

When 10% stock dividend is paid on a share which were price befored $50 (i am assuming dividend is paid on the market price as face value is not given) then stock value shall fall with the dividend paid i.e. $5 (10% of 50) and value after dividend will be $45.

hence option price shall also get down by $5 per share which will result in a loss of $500 (100 shares * 5 per share)..