Synthetic Dividend Definition

What is a synthetic dividend?

A synthetic dividend is an investment strategy in which investors use various financial instruments to create an income stream that mimics that provided by dividend paying companies.

A common example of this strategy is writing covered call options against a portfolio of non-dividend paying companies. In doing so, the investor would realize income from the premiums earned on the options he sells, thereby creating a “synthetic dividend” in his portfolio.

Key points to remember

  • A synthetic dividend is a strategy to derive income streams from a non-dividend paying portfolio.
  • It is usually achieved by selling covered call options.
  • Investors using this strategy should be aware of the particular risks involved, particularly for those who are optimistic about the prospects for substantial appreciation in their holdings.

How Synthetic Dividends Work

Many investors might desire income from their portfolios, despite feeling that the best investments available to them are not dividend-paying companies. For example, many growing businesses don’t pay dividends because they aggressively reinvest earnings in further expansion efforts. Growth-oriented investors might want to derive income from their portfolios, even if they don’t want to deviate from their growth investment strategy.

To achieve this goal, investors can use financial engineering produce a synthetic dividend. A common way to do this is to write covered call options against one or more of the companies of their wallet. In doing so, the investor would receive option premiums option buyer, creating an income stream similar to that provided by dividend-paying companies.

Of course, investors who opt for this strategy should be aware of the particular risks involved. By writing covered call options, they offer the buyer of those options the right to buy their stock at a pre-determined price for a specified period of time. In light of this, the investor may be forced to sell their shares at a time or at a price that they might not otherwise have chosen. Particularly for growth-oriented investors, who are generally enthusiastic about the long-term prospects of their holdings, being forced to sell their stocks in this way could come as an unpleasant surprise.

Example of synthetic dividend

Suppose you are a growth investor whose portfolio consists primarily of shares of XYZ Corporation. The company’s stock is currently trading at $25 a share, and option buyers are currently willing to pay a 5% premium for XYZ call options expiring in a year with a exercise price of $50 per share.

While you’re excited about XYZ’s long-term prospects, you don’t expect its stock price to appreciate beyond $50 in the next year. Additionally, you are tempted by the prospect of receiving an income stream from the 5% bonus, since XYZ currently does not pay dividends.

To capitalize on this opportunity, you sell covered call options against your position in XYZ. However, you realize that by doing so, you are accepting the risk that if XYZ shares exceed $50 per share, you will have lost any share in their price appreciation beyond the $50 level. In this sense, your interests as a growth investor are partially at odds with your desire for short-term income.

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