Synthetic Dividend
What Is a Synthetic Dividend?
A synthetic dividend is an investment strategy where investors utilize different financial instruments to make a flood of income mirroring that given by dividend-paying companies.
A common illustration of this strategy comprises of selling covered call options against a portfolio of non-dividend-paying companies. In doing as such, the investor would acknowledge income from the premiums earned on the options they sell, in this manner making a "synthetic dividend" out of their portfolio.
How Synthetic Dividends Work
Numerous investors could want income from their portfolios, regardless of the inclination that the best investments that anyone could hope to find to them are not dividend-paying companies. For instance, numerous growth companies don't pay dividends since they forcefully reinvest their earnings into extra expansion efforts. Growth investors could wish to acknowledge income from their portfolios, in spite of not having any desire to go amiss from their growth-investment strategy.
To accomplish this goal, investors can utilize financial engineering to deliver a synthetic dividend. A common method for doing so is to compose covered call options against at least one of the companies in their portfolio. In doing as such, the investor would receive option premiums from the option buyer, making a surge of income like that given by dividend-paying companies.
Of course, investors who opt for this strategy must know about the special risks implied. By selling covered call options, they are furnishing the buyer of those options with the right to buy their shares at a predetermined price for a predefined duration of time. Considering this, the investor may be forced to sell their shares all at once or a price that they could not in any case have picked. Especially for growth investors, who are generally energetic about their property's long-term prospects, being forced to surrender their shares thusly may be a seriously unwanted surprise.
Illustration of a Synthetic Dividend
Assume you are a growth investor whose portfolio comprises for the most part of shares in XYZ Corporation. The organization's shares are at present trading at $25 per share, and options buyers are right now ready to pay a 5% premium for XYZ call options lapsing one year in the future with a strike price of $50 per share.
Despite the fact that you are excited about XYZ's long-term prospects, you don't anticipate that its share price should appreciate past $50 throughout the next year. Also, you are enticed by the prospect of getting an income stream from the 5% premium, since XYZ doesn't as of now pay dividends.
To capitalize on this opportunity, you sell covered call options against your position in XYZ. In any case, you understand that in doing so acknowledge the risk that assuming XYZ's shares in all actuality do rise above $50 per share, you will have forfeited any share in their price appreciation past the $50 level. In this sense, your interests as a growth investor are somewhat in conflict with your craving for short-term income.
Features
- A synthetic dividend is a strategy for getting income streams from a non-dividend-paying portfolio.
- Investors who utilize this strategy must be aware of the special risks implied, especially for the people who are bullish on their property's prospects for substantial share appreciation.
- It is commonly accomplished by selling covered call options.
