Tripadvisor had released their earnings report on November 6, 2019. The company announced a surprise $3.50/share “special” cash dividend, meaning it would pay its shareholders $3.5/share in cash. This was actually bad sign…because Tripadvisor is considered to be a small high growth company and paying this special dividend signaled to Wall Street that Tripadvisor isn’t able to reinvest its profits into future high-return projects. As a result, the stock tanked more than 20%!

You see, after the drop, the stock price was now around $32/share. 

Was it that Simple?

Ok, it wasn’t that simple... The day a dividend is paid, a company’s cash balance goes down, in this case by roughly ~$490 Million ($3.50 x ~140 Million shares outstanding). This meant, $490 Million of “value” would exit the company. So we would expect the stock price to fall by an equivalent $3.50/share.

In order to avoid this drop in share price, I thought we could simply hedge our stock position so that if the price falls, we don’t lose money.

How Would We Eliminate This Downside Risk?

To eliminate this downside risk, we could use options.

Recall, a Put option is something that goes up in value if the underlying stock goes down. A Call option goes up in value if the underlying stock goes up. Therefore, we could hedge in three ways:

1. Buy PUT Options

2. Sell CALL Options

3. Buy PUT Options AND Sell CALL Options

If you sell a CALL option, the person you sell to has the right (but not the obligation) to exercise the option (meaning, force you, the seller, to buy 100 shares of the stock at the strike price) at any time between now and until the option expires. If you sell a CALL option, and it is exercised, it means you would be forced to sell 100 shares. Usually this doesn’t happen unless the stock price is trading above the strike price. However, in this situation it could happen even if the stock is trading below the strike. This is because the owner of the CALL option may want to get the dividend that would have gone to you, and is willing to pay extra for the CALL! Sneaky eh?

Let’s see how that works: Let’s assume we sold CALLs with a strike price of $32.50. Let’s say TRIP continued to trade at $32/share. At the time, the $32.5 strike CALL traded at $0.7. If the CALL owner exercised their option, it would cost them $0.7 per option, and you would be forced to sell your shares. Since you would no longer own the shares, you would no longer be entitled to the special dividend. Instead, the person who exercised the option would now own the shares and they would receive the dividend!

Of course, this may not have happened...but, it was a very plausible scenario. To avoid the above situation, I would have preferred to hedge using PUT options. 

Hedging with PUT Options

So, which PUT option should we have bought and how much would it cost us?  

Let’s first define our profit objective:  

At the then current stock price of $32/share, I looked up PUT option prices with the following strike prices ($33, $32.5, $32, and $31). This is a decent range both above and below the current stock price. The table below shows the profit potential assuming the stock price at the end of Friday Nov 22 (aka at expiration) was between $30-$34. 

Since we were expecting a decrease in stock price when the dividend was paid out, the table was telling us that we should have bought PUTs with a strike price above the current stock price, so PUTs with strike >= $32.

Practically speaking however, such puts may have wide bid-ask spreads (i.e the difference between what someone is willing to buy a PUT for vs what someone is willing to sell a put for). The higher the strike, the higher the spread, so you may not actually be able to purchase those PUTs for a reasonable price. As such, since you pretty much get the majority of the benefit with the $32.5 PUT, I would have bought these.

Was this Really Risk Free?

The primary risk in my opinion was if the company didn’t actually pay the dividend. This was extremely unlikely since the company had just announced this special dividend...why would they have announced it otherwise?

What Was Missing From This Analysis?

Special Dividends have an interesting impact on Option Contracts. They actually alter the strike price! According to the contract rules, each option contract’s strike price would actually change the day of the special dividend, meaning the above mentioned $32.5 PUTs would instead become PUTs with a strike of only $29! And hence our stock positions wouldn’t have been hedged at all... Surprise!!

In fact, the guaranteed gain of ($2.3/share or 8.4%) would actually have turned into a guaranteed loss of ($1.2/share), the cost of the PUT options! (since the dividend captured would cancel out the $3.5 drop in stock price).

In Conclusion

It’s amazing that option prices don’t simply adjust when a special dividend is announced (like they do for regular dividends) but instead they cause the option strikes to adjust instead.

So…as they say, when things seem too good to be true, they probably are…