What Is a Synthetic Dividend?

Synthetic dividend is an investment strategy in which investors use various financial instruments to create a stream of income that mimics that provided by dividend-paying companies.

A common example of this strategy consists of selling 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 they sell, thereby creating a “synthetic dividend” out of their portfolio.

Key Takeaways

  • A synthetic dividend is a strategy for deriving income streams from a non-dividend-paying portfolio.
  • It is commonly achieved by selling covered call options.
  • Investors who use this strategy must be mindful of the special risks involved, particularly for those who are bullish on their holdings’ prospects for substantial share appreciation.

How Synthetic Dividends Work

Many investors might desire income from their portfolios, despite the feeling that the best investments available to them are not dividend-paying companies. For example, many growth companies do not pay dividends because they aggressively reinvest their earnings into additional expansion efforts. Growth investors might wish to realize income from their portfolios, despite not wanting to deviate from their growth-investment strategy.

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

Of course, investors who opt for this strategy must be aware of the special risks involved. By selling covered call options, they are providing the buyer of those options with the right to buy their shares at a predetermined price for a specified duration of time. In light of this, the investor might be forced to sell their shares at a time or a price that they might not otherwise have chosen. Particularly for growth investors, who are generally enthusiastic about their holdings’ long-term prospects, being forced to cede their shares in this manner might be quite an unwelcome surprise.

Example of a Synthetic Dividend

To illustrate, suppose you are a growth investor whose portfolio consists mainly of shares in XYZ Corporation. The company’s shares are currently trading at $25 per share, and options buyers are currently willing to pay a 5% premium for XYZ call options expiring one year in the future with a strike price of $50 per share.

Although you are enthusiastic about XYZ’s long-term prospects, you do not expect its share price to appreciate beyond $50 over the next year. Moreover, you are tempted by the prospect of receiving an income stream from the 5% premium, since XYZ does not currently pay dividends.

To capitalize on this opportunity, you sell covered call options against your position in XYZ. However, you realize that in doing so accept the risk that if XYZ’s shares do rise above $50 per share, you will have forfeited 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.