Dear All:
“When dividend payments occur during the life of the option, the price of the underlying stock is reduced (on the ex-dividend date). All else being equal, the lower price reduces the value of call options and increases the value of put options.”
I really don’t undertand this rationale; why is that the lower stock price reduces the call option price and increase the put option?
Thank you so much for your time.
Think about the payoffs.
For call options, you want the underlying stock price to be as HIGH as possible. The more the in-the-money the option is (ie stock price > strike), the more valuable the option. A reduction in srock price takes the option more towards being out-of-the-money.
The opposite is true for puts. You want as low a stock price as possible bc the put gains value when the share price falls (bc you can now put the share back at a strike price that is above the market price).
Hope that helps
BMiller12 is right and that’s the answer you want to say on the exam. However, in reality markets are very smart and effiicient, where such thing does not happen. The drop in price due to dividend is known well ahead of time giving option pricing a chance to adjust. So the value of the call does not drop suddenly. Having said that, there are occasional inefficiencies that I personally witnessed first hand, which could make you a handsome profit if you play it well.