Dividend per share (DPS) is the amount of dividend receivedby the shareholder on a per share basis. The company distributes dividend outof the profits of the company after deducting tax (PAT). The overall appeal ofa company increases when it pays regular dividend, and hence attracts severalbuyers. If you want to diversify your portfolio profitably, dividend surely issource of a little extra income. It is observed in the BSE and NSE share market that a companywith constant profits that issues dividends tends to be more trustworthy andprone to high share sales in the market. Below is a brief explanation of howstock and options are interlinked with the rate of dividend of a given companyso as to help you take effective investment decisions. Let us first understandthe effect of dividend on stock prices.
1.How DividendAffects Stock Prices
A dividendonce announced can have a short term fluctuation or show long term effects onthe stock prices. Trends in the stock market may change for the good or badbased on the rate of the dividend.
Dividend Rate Fluctuation
If thedividend announced is higher with respect to the expectations of speculators,the market will experience a rise in the stock price of the company. If you ownsuch shares you can choose to sell it off at a profit, or retain it whileenjoying a good dividend. Turned the other way round, if the dividend announcedis lower than the expectations of speculators, the stock prices tend to go lowwith a display of low profitability in the current year. You will not only seeyour share value fall, but also earn a lower dividend. Several investors actquickly based on the slightest indications of the expected dividend before itis even announced. This adds to the volatility of the stock market.
Announcement of Ex-Dividend
On the Ex-dividenddate, the price of the stock falls by the dividend amount, though it eventuallymoves back to its previous price in time. This is because the cash now beinglabelled as dividend is not a part of the company’s earnings. Generally, when acompany announces its dividend, the amount of declared dividend is added to thestock price. As the company sets an ex-dividend date, any investor purchasingstock before the same is eligible for dividend payment. In case the stock ispurchased on or after the ex-dividend date, the dividend will be paid to theseller of the stock.
Announcement of Special Dividend
Aspecial dividend, also known as anextradividend, is aone-time distribution of corporate earnings to company shareholders. It usuallystems from exceptional profits during a given quarter or period, for example,the sale of an overseas branch or subsidiary. If the cash flowing in throughsuch a transaction is exponentially huge, the company may revise the rates ofthe share altogether. Since you get paid for simply owning your shares, (say,Rupees 100 each) many people would like to buy in just to get the specialdividend (say, Rupees 75 per share). The stock price of the shares would risein the market due to new demand. On the ex-dividend date it would fall byRupees 75; as the stock price gradually moves back to its previous price ofRupees 175, the rate change becomes permanent.
After understanding the effect ofdividend on stock prices, let us delve into knowing the effect of dividend onstock options.
2.Effects ofDividend On Stock Options
A Stock Option refers to aprivilege, where the purchaser and seller enter into an agreement to sell thestock at a predetermined price on a given date. The purchaser has the right tobuy or sell a stock, but is under no obligation to do the same. Every time acompany declares dividend, the stock price is discounted by the market. Thisleads to a lower market price per share of the ex-dividend price. The price change that the stock goes through due toex-dividend also has an impact on the price of options, namely Call and Put.
What is Call option
A Call refersto when a purchaser enters into contract to buy stock on a certain date for acertain consideration. The decline of the stock price on the ex-dividend dateresults in a decline in the value of call options. The declaration of dividendobserves a decrease in the premium of the call option.
What is Put option
A Put refersto when a seller makes a contract to sell his stock on a certain date for acertain amount. When the prices of the stock drop due to dividend declaration,the value of put option always rises. This is because the stock price reducesby the amount of dividend to be distributed. This effect is the reverse of whatwould happen to a call option.
Bottom-line
The smart way to invest in stock markets would be to keep aneye on companies with consistent profits and returns to the shareholders. Astrong company always gives back to its members. Hence the biggest signs of acompany worth investing in lies in their returns. One should be cautious enoughto verify in case of high dividends, that the company actually earns profitshigh enough or is deceptively trying to hook immature investors. Even thoughdividends are not the only criteria to investing and trading, knowing howdividend income can boost your profits is essential.
AtIndira Securities, we help you make the right trading and investingdecisions through our blogs written specially for stock market enthusiasts.
Happy trading!
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