What it means
Many growth companies do not pay dividends because they prefer to reinvest profits. An investor who holds such shares but needs regular income has a problem, since the shares generate no cash.
A synthetic dividend is a way to solve it. The first method is the covered call, where the investor owns the shares and sells call options on them, collecting a premium each time.
If the shares stay below the strike price, the options expire and the investor keeps the premium and the shares. Repeating this each quarter produces a stream of income that looks like a dividend.
The second method is simply to sell a small fraction of the holding on a schedule, say 1% each quarter. Some investors call this a homemade dividend, and it is similar in effect to a systematic withdrawal plan.
Either way, the cash comes from the portfolio, not from the company. Each method has a catch.
With covered calls, if the share price rises above the strike, the shares can be called away and the investor loses the extra gain. With share sales, the portfolio shrinks over time if the shares do not grow fast enough, and each sale may create a taxable gain.
Tax treatment also differs from a real dividend, and the rules vary by country. Option premiums and capital gains may be taxed differently from dividends, so investors should check the treatment before relying on the income.
A synthetic dividend can still be useful, but it is not free money, and the income is less certain than a dividend from a stable payer.
In practice
Real-world examples.
Example
A retired engineer holds shares in a technology company that pays no dividend. He sells covered calls every three months and receives about $2,400 a year, which helps to cover his utility bills.
Example
A family trust needs $20,000 a year in income from a portfolio of growth shares. The trustees sell 2% of the $1,000,000 holding each year instead of selling options, which keeps things simple and records each sale for tax.
Example
A small business owner holds shares in a start-up that she backed years ago. She uses covered calls on part of the holding and treats the premiums as a dependable side income while she waits for the company to grow.
Formula
Calculation
Synthetic dividend yield = Annual option premium income / Value of the shareholding
Suppose an investor owns 1,000 shares of a non-dividend-paying company at $50 each, worth 1,000 x $50 = $50,000.
Each quarter she sells covered calls with a strike of $55 and receives a premium of $0.75 a share.
Quarterly income = 1,000 x $0.75 = $750
Annual income = $750 x 4 = $3,000
Synthetic dividend yield = $3,000 / $50,000 = 0.06, or 6%
If the share price rises above $55, her gain is capped at $55 - $50 = $5 a share plus the premium, so a rally to $70 would have earned an extra $15 a share, or $15,000, had she not sold the calls.Case study
Seen in the real world.
Fennimore Capital is an illustrative, fictional advisory firm with a client who held $400,000 of a single growth share that paid no dividend. The client wanted $16,000 a year in income without selling out completely.
The adviser proposed selling covered calls on half of the shares each quarter. The premiums averaged about 1.5% of the value of those shares per quarter, which on $200,000 comes to $3,000 a quarter or $12,000 a year, and the client sold 2% of the remaining $200,000 of shares annually to cover the other $4,000.
In the illustrative first year the share price rose sharply and one set of calls was exercised, so the client missed some upside. The adviser used the episode to explain that the income had a price, and the client chose to write calls on a smaller portion of the holding the following year.
Watch out
Common mistakes.
- Treating option premiums as guaranteed income, when they depend on volatility and on the share staying below the strike.
- Ignoring the cap on gains, which means a strong rally can leave the investor with less than if she had simply held the shares.
- Forgetting tax, since premiums and gains from sales may be taxed differently from dividends.
Questions
People also ask.
Is a synthetic dividend the same as a real dividend?
No, a real dividend is paid by the company out of profits, while a synthetic dividend is created from the investor's own holdings and options.
What is a covered call?
It is an option sold against shares you already own, so you can deliver them if the option is exercised.
Who uses synthetic dividends?
Investors who hold growth shares but want regular income, such as retirees, trusts and income-focused funds.
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