Interesting question from a reader about an obligation to pay a dividend because of an early assignment. The reader cites the following example from the CBOE website training center;

Buy XYZ stock at $50
Buy 1 XYZ March 50 call at $3.00
Sell 2 XYZ March 55 call at $1.50

In this example, the trader is short 2 XYZ March 55 calls, one of the calls is “covered” by a long position in XYZ stock, the other is “covered” by a long XYZ March 50 call. 

If we assume that the stock price is above $55 on expiration day, the XYZ 50 call will be exercised, the XYZ 55 call will be assigned. All 200 shares will be sold upon assignment. So far so good!

But, according to the CBOE, “there is a possibility of an early assignment on the XYZ 55 calls which may result in an obligation to pay a dividend.” 

Our reader asks “what does it mean when one is obligated to pay the dividend on early assignment of covered calls?”

The first pass through this question yields a simple answer. In a worst case scenario, you would be responsible for a dividend payment on only 100 shares of XYZ, if both XYZ 55 calls were assigned early. 

But that’s only a partial answer. For greater depth, you need to understand that call buyers will sometimes exercise their position in order to capture a dividend. 

Suppose, for example, XYZ was scheduled to pay a 50 cent per share dividend in April, and the ex-dividend date was say, March 11th, well before the March 22nd expiration date. In other words, someone buying XYZ on March 10th would receive the April dividend payment, whereas, someone buying the shares on March 11th, would not receive the April dividend. 

With that preamble, let’s assume the following prices exist on March 10th;

XYZ is at $59.00 per share
XYZ March 55 call is at $4.00 per share

In this case, the XYZ March 55 call is trading at its intrinsic value. Which is to say there is no time value in the option contract. The trader who owns the 2 XYZ March 55 calls could exercise the calls on March 10th, which would guarantee that he would receive the April dividend. 

You as the seller of those 2 XYZ March 55 calls would not receive the assignment notice until March 11th. Of course you own 100 shares of XYZ, so for one of the assignments you will simply deliver your 100 XYZ shares. In this process, forfeiting the April dividend, because the shares now belong to the call buyer who exercised his position. 

The problem is that you were short two XYZ March 55 calls. Since you will only become aware of the March 10th assignment on the morning of March 11th, you will have to go into the market on March 11th (the ex-dividend date) and purchase 100 additional shares of XYZ to answer the assignment notice. 

You can be buy those shares on March 11th, though a purchase in the open market or by exercising your XYZ March 50 call. But in either case, you will be buying on the ex-dividend date, to meet an assignment notice that occurred on the cum-dividend date (i.e. the day before). As such, you would be responsible for delivering a dividend on 100 shares of XYZ to the call buyer.