Synthetic Dividend

  

Categories: Stocks

Think of it like powdered milk. Not exactly what you dream about when your grandma sends you a care package of cookies. But it works okay if the real stuff isn't around.

Dividends are cash payments companies make to stockholders. You own 100 shares of a firm that issues a quarterly dividend of $1 a share. Every three months, you get a check for $100. It's income generated just by holding a stock. Many stocks don't pay dividends. If a company believes it can create more value by reinvesting funds in it's business, it will keep the cash itself instead of sending checks to its shareholders. However, if you own these stocks, there are still ways to generate income from the shares. They aren't dividends, really. But, like dividends, they represent income you get from the shares you hold.

The most common way to create synthetic dividends is using covered call options. A call provides the holder the right, but not the obligation, to buy a stock at a certain price during a certain time frame. With this form of synthetic dividend, you sell this right to someone else. You receive a premium from the contract...income from your shares.

The potential downside comes if the person chooses to exercise their option. Now you have to sell the shares at the prearranged price, which might be below the current market price for the stock.

Related or Semi-related Video

Finance: What is a Derivative?23 Views

00:00

finance a la shmoop what is a derivative? well it's derived it's a something taken

00:10

from something else like a derivative of hot weather is thirst a derivative of [Girl takes sip of glass of water on a beach]

00:16

hunger is well you know crankiness that's diva thing you get there...

00:20

derivative of a 1/32 quarterback rating in the NFL is like serious wealth yeah

00:26

yeah discount double shmoop yeah look for it be on there with aaron

00:30

and a derivative of a stock or bond or other security is a something which

00:35

derives its value based on the performance of that underlying security

00:40

there are basically two flavors of derivative put options ie the right to [Ice cream flavors appear]

00:44

sell a security at a given price over a given time period and a call option, ie

00:49

right to buy a security at a given price over a given time period

00:52

well the price of that option is derived from the price of the security and a few

00:59

other factors like strike prices and duration and all that stuff

01:05

colonel electric the downgraded new version of General Electric is trading [Colonel Electric appears in a suit]

01:10

for 25 bucks a share a derivative of its share price is sold in the form of a

01:15

call option with a $30 strike price expiring about 90 days from now on the

01:19

third Friday of the end of that month well investors pay a price albeit

01:24

probably a small one for the right to then pay 30 bucks a share for colonel [Call option appears for colonel electric]

01:29

electric at any time in the next 90 ish days until that option expires making the bet

01:34

that the stock will go well above 30 bucks a share in that time period that

01:39

call option is thus a derivative of the colonel electric primary stock price got

01:45

it if you really want to get personal well here's the ultimate form of

01:49

derivative [Baby laying down]

Up Next

Finance: What is a Dividend?
1777 Views

What's a dividend? At will, the board of directors can pay a dividend on common stock. Usually, that payout is some percentage less than 100 of ear...

Finance: What is Payment in Kind/PIK?
44 Views

What is Payment in Kind/PIK? PIK is the technical term for barter payment. If you give your plumber a pair of tickets for an NFL game that are wort...

Find other enlightening terms in Shmoop Finance Genius Bar(f)