Every so often we will see a company declare a “special dividend” which is separate from the typical recurring dividend cycle, if there is one. It is frequently a reflection of exceptionally strong earnings and/or a company with a large cash balance. It is a positive sign regarding the financial health of this corporation. Some of you may remember the $3, 1-time cash dividend announced by Microsoft in 2004 to “relieve its balance sheet of a large cash balance”…such problems we should all have! When a stock generates a special cash dividend, let’s say $1 per share, the price of the stock is then adjusted by decreasing by that amount. This adjustment will take place the day AFTER the dividend is distributed. Now I can see the wheels turning in your heads…I’ll buy the stock on the record date and sell it before the price adjusts for this distribution…I’m going to make out like a bandit! Not so fast…don’t quit your day job. The earliest you can sell your stock and still be entitled to the special cash dividend is the date the stock begins trading on an “ex-distribution basis”, or one day after the dividend date. Oh well.

Now let’s bring this information into our world of covered call writing. We sell call options which implies that someone is buying them (we’re the “casino” …they’re the players). Let’s say we buy a stock for $69 and sell the $70 call. The holder of that call option bought the call with the strike $1 higher than the market value of the stock. If a $1 cash dividend is distributed prior to expiration causing the stock price to be adjusted down by $1 his position would be dramatically compromised. To make this situation fair and the option buyer “whole” the strike price is decreased by the dividend amount or $1 in this scenario. So a $70 call becomes a $69 call. All other factors being equal, the market value and strike drops an equal amount and so the strike is still $1 from the market value.

Where to get information on special cash dividends

www.cboe.com

www.optionsclearing.com

Real life example

On August 11, 2011, HollyFrontier announced a special, 1-time cash dividend of $1. Here is what that information looked like on the second site listed above:

HFC- Special cash dividend

Here is a chart taken from the CBOE site reflecting the change in the strike prices:

HFC- Change in strike prices

How to calculate our covered call returns

If we bought a stock for $69 and sold the $70 call for $3, our initial calculation would be:

ROO= $3/$69 = 4.3%

When we receive a cash dividend of $1, in essence our cost basis is reduced by $1 or $69 becomes $68:

ROO = $3/$68 = 4.4%

Our long stock position is decreased by $1 and that is why I don’t like to calculate the extra $1 as additional option premium. It would skew the results and not account for the reduced share value:

$4/$69 = 5.8%

These calculations are NOT for tax purposes. They are used to assess the best covered call decisions at that specific point in time.

Strike prices if the dividend were not an even number

The OCC Security Committee evaluates each situation on a case-by-case basis but generally speaking if a dividend if greater than 12 1/2 cents the strike price can be adjusted by the amount of the dividend. If HFC had declared a 1-time cash dividend of $1.25, the $70 strike would become $68.75. As new series of options are published, the standard strike prices will return.

Special dividends in the form of shares instead of cash

Once again contract adjustments are done on a case-by-case basis but generally speaking if a 5% stock dividend was declared on a $30 stock:

• Share value is determined by the following equation: $30/1.05 = $28.57
• The new strike price will be $28.57
• Each contract will now deliver 105 shares instead of the original 100

Conclusion

Special cash dividends will frequently impact our strike prices due to the decrease in share value after the distribution. Because these are handled on a case-by-case basis it is important to understand how your position has changed due to the unexpected cash or stock distribution. The websites I referenced above are great resources for locating this information as are specialists who work at your brokerage.

My 4th book:

Editing has been completed and just needs my final approval. This is a general stock and mutual fund investment book geared to high school and college age students. It is the book I’ve always wanted to write. I anticipate publication this summer and I will make the book available to our members at an early discounted price before it is available on Amazon.com.

My next live seminar:

Despite my plans to take the summer off from live events, I did accept an invitation from The Money Show to host two presentations at one of their great events, The San Francisco Money Show Expo on August 16th:

http://www.moneyshow.com/tradeshow/san_francisco/moneyshow/speakers/speaker_details/?speakerid=891071A

Money Show interview:

I was interviewed several times at the recent Las Vegas Money Show Stock Traders Expo. Here is a link to one of those interviews:

http://www.moneyshow.com/video/video.asp?wid=9305&t=3&scode=031070

Market tone:

It’s been a challenging few weeks as the VIX (CBOE Volatility Index) has moved between 12 and 17 but remained under the 20 level during this time frame. It was a lean week for economic reports:

• Retail sales (a report of the dollar value of sales of a broad range of goods, from cars and gasoline to furniture, food services, and clothing. Retail sales are a major indicator of consumer spending trends, accounting for a substantial portion of total consumer spending and aggregate economic activity) rose by 0.6%, more than the 0.4% expected mainly due to a strong demand for cars
• Producer prices increased by 0.5% in May, more than the 0.1% anticipated due to an increase in gas and food prices
• The Producer Price Index or PPI (a measure of the average change over time in the selling prices of a fixed basket of goods by stage of production, industry, and commodity. It is considered a leading indicator for consumer inflation. The “core” PPI excludes food and energy prices—which account for roughly one-quarter of the broad PPI and tend to fluctuate widely—providing a truer reflection of inflationary trends) saw a rise of 0.1%
• Industrial production ( a measure of the changes in quantity of physical materials and items produced in the manufacturing, mining, and utilities industries) was unchanged in May
• Business inventories rose by 0.3% in April as analysts predicted
• Initial jobless claims for the week ending June 8th came in at 334,000, below the 345,000 expected
• Low market volume muted cause for excessive concern

For the week, the S&P 500 declined by 0.1% for a year-to-date return of 16%, including dividends.

Summary:

IBD: Confirmed uptrend

BCI: Cautiously bullish using an equal number of in-the-money and out-of-the-money strikes

My best to all,

Alan ([email protected])

www.thebluecollarinvestor.com