Options and Microsoft's Special Dividend

Steve,

I need some clarification ... given that Microsoft (MSFT) will give a $3-per-share dividend in November, payable in December, how would you expect November, December or January Microsoft options to react?

-- Russ

After Microsoft's July 20 announcement that it will pay out a special cash dividend of $3 per common share to stockholders, I quickly got a barrage of email from readers concerned about the move's impact on related options. My initial explanation was very brief, and despite my best attempts to answer all reader email individually, the queries keep piling up. So it makes sense now to run through the timeline of the distribution and how this will affect option pricing and valuation.

The date of record to qualify for this special dividend is Nov. 17, 2004. Given the standard three-day settlement period, that means the ex-dividend date -- the day one must own the stock at the close of trading -- is Nov. 12. The actual cash distribution will be made on Dec. 2.

Consistent with past standard practices for special payments or one-time dividends, the Options Clearing Corp. said it would adjust the strike prices of Microsoft options to reflect the special one-time dividend effective on the ex-distribution date. While the best guess is that will occur on the morning of Dec. 3, according to the latest release from the Options Clearing Corp., the ex-distribution date has yet to be finalized, as all is still subject to the official shareholder approval currently planned for voting on Nov. 9.

Assuming that all goes according to plan, all active options strike prices will be reduced by $3, or the equivalent of the special dividend. For example, all options with a $25 strike price and expiration date from December 2004 through the January 2007 LEAPs will carry a $22 strike price, all $20 strikes will become $17 strikes, all $30 strikes will become $27 strikes, etc. The symbols will all remain the same and each option contract will still represent or control 100 shares of Microsoft common stock.

But the more pressing and confusing question is what happens in the meantime, or, as one reader worries, "does this mean I will immediately lose money the next day after the special dividend because my calls will be worthless? And if so, how do I position for this fall?" The answer is a qualified no: You needn't worry about losing money in the call options you own.

The exact date of distribution (commonly known as the ex-dividend date) has not yet been finalized. But one can expect, all else being equal, that on that day, shares of Microsoft will decline by $3 per share. It's on this same day that its options will be adjusted by reducing the strike prices by $3.00. Therefore, the options values both before and after the the special dividend is distributed will accurately reflect the current share price. There is no free money available by purchasing put options just prior to the ex-date and little danger that $25 calls will suddenly be "out of the money."

This is important for all strikes that are in the money, leading to this frequently asked question: "I would like to buy some covered calls and then buy the corresponding puts (so that I am hedged) just before the ex-dividend date so that I can collect the dividend. Do you see any flaws with this logic?" In other words, is there some way to take special advantage of this special dividend?

Although the special dividend will make Microsoft shares fall when the stock goes ex-dividend, the payment itself will have little impact on the option premiums. You can expect that all call options that are in the money with an expiration before the December strike price adjustment (or contracts people simply don't wish to hold until the adjustment date) will be exercised by those wanting to own the shares and qualify for the payment.

For example, if Microsoft shares are trading at $25 on Nov. 12 and the Nov. 20 call is worth $5, expect both to drop $3 on the ex-dividend date. But after the Dec. 2 distribution, the $20 calls will become $17 calls; they will still have an intrinsic value of $5, assuming that Microsoft stock is trading at $22 that day.

So while there is no flaw in the reader's logic of establishing the above-described collar, it also holds no distinct advantage over simply buying Microsoft shares or in-the-money options before the ex-dividend date. As a prior article on capturing the dividend explained, in order to skate away with a risk-free collection of a dividend payment, you are really counting on someone simply forgetting to exercise their in-the-money options. With less then an average of 0.5% in-the-money options going unassigned for dividends of 25 cents or greater, I doubt there will be a case of collective amnesia when $3 per share is at stake. So if you own an in-the-money option, especially one with a November expiration, don't forget to sell it or exercise it before the ex-dividend date.

One other item that has not been discussed or received much attention yet is the impact Microsoft's dividend might have on exchange-traded funds like the Nasdaq-100 Trust ( QQQ), HOLDRs or iShares, of which it is a major component, and their related options.

According to the Options Clearing Corp., all ETFs that include Microsoft will be adjusted to reflect the amounts of such distributions attributable to the Microsoft special cash dividend, provided that the impact of the special cash dividend on the ETF or HOLDR equals or exceeds 12.5 cents per share.

Essentially, if the special dividend has an impact of greater than 12.5 cents, the strike prices of the affected ETF, HOLDR or iShare will be adjusted in accordance to the same process described above that the common equity options will undergo. This could be a nightmare, to have options with 10-cent or 15-cent strike prices. Thankfully, the numbers are still to be crunched (the fund trust administrator is responsible for the determination; in the case of the QQQs, that is the Bank of New York). And no ETF has yet been identified as needing an option strike price adjustment.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

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