Traders who want to be in and out of positions short term, tend to ignore or undervalue dividends altogether. Because the dollar amount is quite small compared to a stock transaction, dividends often are viewed as nuisance factors to short-term traders. On the far end of the spectrum, value investors might ultimately pick one value investment over other choices based mainly on the dividend yield of the moment.

The point is, traders and investors cannot just buy stocks yielding higher than average dividends and expect to outperform the market. Dividend risk is one form of risk that is easily ignored or misunderstood. So while dividend yield can represent a major portion of overall yield, it has to be balanced against market risk. The dividend collar developed throughout this book is based on generating income from dividend yield, but the most crucial component of that strategy is protecting against the inherent risks that can accompany high-dividend stocks, at times to a greater extent than market risk in the overall equity market.

With this in mind, the higher the dividend yield, the better the overall return will be as well. Does this mean that selection of a covered call candidate should be limited to only those stocks yielding better-than-average dividends? No. In fact, in comparing only the covered call strategy (without considering any other hedging that might be included) the appropriate underlying stock should be selected based on sound fundamental analysis, and not on the basis of (1) richer-than-average option premium or (2) higher-than-average dividends.

Remembering that attractive yields often accrue because a company’s share price has plummeted, selecting covered call candidates based solely on dividend yield is quite dangerous. Share price might have fallen due to any number of causes, including the impending demise of the company and anticipation of a further price decline in the stock. In this case, a 7% yield on a stock yielding only 1.2% a few months earlier is not likely to be a sound candidate for covered call writing.

Assuming, however, that you have narrowed down selection for covered call writing to three different companies, and also assuming that all three share the same or similar fundamental attributes, how do you know which to purchase for a covered call strategy? While you can apply a number of sensible fundamental (or technical) criteria to pick one of the three, dividend yield may certainly act as one deciding factor.

This decision is not merely a matter of opting for the highest dividend yield. Depending on your analytical standards and on the ratios and trends you follow, you are likely to prefer one company over others without consideration of the dividend level. However, as a starting point for describing any options strategy, it makes sense to analyze the components that are included; how those components affect value; and what levels of risk are caused or mitigated as a result. Dividend yield is one of those components, and traders have struggled for years to determine the role of dividends and their effect on option valuation.

Pricing models for options have provided a dismal indicator. The most popular among these, the Black-Scholes Pricing Model,¹ is a very flawed method for identifying fair value for options, because it contains several variables and excludes many important attributes that make the model inaccurate. These include

The complexity of how dividends and interest rates affect option valuation is not a small issue. Dividends are certainly a direct component of option and stock valuation, and interest affects the valuation of both calls and puts. It is noteworthy, however, to recognize that at the time the Black- Scholes model was devised, there was no standardized trading of puts in the US markets. In fact, even calls were available on the stock of only 16 companies.

Black-Scholes works as a pricing model in a comparative sense; however, it is so inaccurate that it provides little value in terms of changes in interest rates, and no value for dividend-paying stocks. The factor for volatility is based on assumption that the volatility level remains constant. The Black-Scholes formula is

Among those flaws is the assumption that a risk-free interest rate exists. That is unlikely today, when even the debts of the US government have been downgraded. This does not mean they are likely to default, but it does take away the historical risk-free assumption related to Treasury securities.

Interest rates affect option values directly and also serve as a guide for when or if to exercise an option early. If interest that can be earned on the proceeds received for selling a put at a higher level than is possible from holding until expiration, then early exercise is justified, at least in theory. This assumption is based on the additional assumption that if you close out an option position, you will immediately transfer capital to an instrument yielding a more favorable net return. This is the rationale often cited in support of Black-Scholes and similar pricing models. But in the modern-day environment of very low interest rates, this comparison is not valid. When it is possible to earn as much as 4–5% or more on stock ownership, the dividend yield is a far more important measure of return than interest rates for those companies could ever expect to be.

Dividends are likely to have much greater impact on option valuation than interest rates, notably when early exercise before the ex-dividend date is compared with exercise on or after the ex-dividend date. A general assumption about dividends is that the higher the cash dividend, the lower the call premium and the higher the put premium. While there is truth in this general rule of valuation, traders will still want to time their exercise decisions to be stockholders of record two days after the ex-dividend date—and this might lead to a decision to time entry and exit, even more than the relative value of the dividend yield or potential yield from closing stock and option positions and investing elsewhere.

These decisions are complicated by the additional considerations of whether the option is in or out of the money, the rate of time decay, and whether in-the-money (ITM) calls are vulnerable to exercise as the ex-dividend date approaches. The day before the ex-dividend date is the second most likely time for exercise, after the last trading day. Thus, proximity of the short call to current price is a crucial factor in option valuation, meaning that dividend yield is a key factor in the overall evaluation of options. It is not just proximity but time as well as actual yield that determines the option’s fair value.