What is a Synthetic Dividend
A synthetic dividend is a type of incoming cash flow that an investor creates with certain financial securities to produce a dividend-like payment stream that resembles the periodic cash receipts from a dividend-paying stock.
BREAKING DOWN Synthetic Dividend
Investors create synthetic dividends in cases where assets, such as stocks and ETFs, normally do not pay a dividend. The strategy resembles a dividend, but investors must keep in mind that there is more risk involved because options are used and share-price gains may be limited.
How Synthetic Dividends are Created
For example, suppose an investor owns shares in a company that does not pay a quarterly dividend. In order to create a cash-flow stream from the shares, the investor could write covered call options on the underlying stock. By doing so, the investor would receive the option premiums as an incoming cash flow, but would be obligated to sell the shares to the option-buyer should that person choose to exercise the options.
Stock owners have the right to sell your stock at any time for the market price. Covered call writing is simply the selling of this right to someone else in exchange for cash paid today. This means you give the buyer of the option the right to buy your shares before the option expires, at a predetermined price, called the strike price.
A call option is a contract that gives the buyer of the option the legal right (but not the obligation) to buy shares of the underlying stock at the strike price any time before the expiration date. If the seller of the call option owns the underlying shares the option is considered "covered" because of the ability to deliver the shares without purchasing them in the open market at unknown – and possibly higher – future prices.
This situation, while limiting the potential price appreciation the investor can realize from his or her own shares, creates a dividend-like cash flow stream. Keep in mind that if you want to sell your shares before the expiration of the call, you must buy back the option position, which will cost you extra money and some of your profit.
For this strategy, many investors look to stocks of solid, stable companies that for one reason or another do not pay a dividend. A prime example is Warren Buffett's Berkshire Hathaway. Buffett doesn't believe in paying dividends, but with this strategy, an investor can go his or her own way.