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People who trade options do so for a number of reasons: to target downside protection, to potentially enhance income from stocks they own, or to seek capital-efficient directional exposure, to name a few. But one common element shared by all option traders is exposure to risk.

Consider dividend risk. If you trade options on stocks that pay cash dividends, you need to understand how dividends affect options prices, options exercise and assignment, and other factors in the life cycle of an option.

To make a long story short: Failure to understand dividend risk could derail your strategy and cost you money.

How Do Cash Dividends Work?

Dividends, stock splits, mergers, acquisitions, and spin-offs are examples of corporate actions—things done by a company that require adjustments to the number of outstanding shares or the share price in order to keep the inherent value of each share consistent before and after the corporate action. Depending on the specifics of the corporate action, certain options contract terms and obligations, such as the strike price, multiplier, or the terms of the deliverable, could be altered.

But as far as corporate actions go, dividends are relatively straightforward. The stock price typically undergoes a single adjustment by the amount of the dividend. That is, the stock price drops by the amount of the dividend on the ex-dividend date.

So, for example, suppose a stock trading for $50 per share declares a $0.50 dividend. After the ex-dividend date (all else equal), it becomes a $49.50 stock (plus the $0.50 dividend) to the owner of each share as of the “record date.” That’s the cutoff day, set by the company, for receipt of a dividend. And that’s it—no changes are made to the listed options strike prices or contract terms.

From a shareholder standpoint, it’s essentially an even swap—$50 in stock versus $49.50 in stock plus $0.50 in cash—but call and put options prices must account for the decline in the stock value and adjust accordingly.

It’s important to note, though, that this adjustment to options prices isn’t a sudden, unexpected change right after the ex-dividend date. Option traders anticipate dividends in the weeks and months leading up to the ex-dividend date, so options prices adjust ahead of time.

Put options generally become more expensive because the price drops by the amount of the dividend (all else being equal). Call options become cheaper because of the anticipated drop in the price of the stock leading up to the ex-dividend date.

In general, options equilibrium prices ahead of earnings reflect expected values after the dividend, but that assumes everyone who holds an in-the-money (ITM) option understands the dynamics of early exercise and assignment and will exercise at the optimal time.