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Author: Rayvt Big gold star, 5000 posts Top Favorite Fools Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75340  
Subject: Re: Retirement, college, and Obamanomics Date: 1/2/2013 10:09 PM
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The company never bought the index (only the call option), therefore they did not receive any dividends. That actual owners of the stock, whoever they be (but in our case clearly not the policy holder or the company), received the dividends.
Derivatives are complex and difficult to grok. Which means it is easy to misunderstand them throughly. Investing in an instrument that you don't have a complete and accurate understanding of -- generally means that you are gonna get whacked sooner or later, completely unexpectedly.

The holder of a call indeed doesn't directly collect the dividend, true. But he does, however, indirectly get the dividend by the fact that the price of the option is lower than it would be if the stock didn't pay a dividend. So this is one of those areas where the literal truth is false in effect. Which generally results in the contents of your wallet being transferred to a counterparty who *does* accurately understand the big picture.

Follow the transactions:
A owns the stock.
A sells a call to B.
A is therefore net neutral. Buying the stock makes him long. Selling the call makes him short. The short cancels the long, so he is neutral.
Being long means you collect the dividend.
Being short means you *pay* the dividend.
Being neutral means that you neither collect or pay the dividend.

A is neither long nor short. Which means that B is long. Which means that B receives [the benefit of] the dividend.

When you follow it all, you'll see that it *has* to be this way. Otherwise there would be a risk-free opportunity for somebody to collect the dividend while being neutral in the stock. But there is only ONE dividend, so that would mean that somebody else would be long the stock but would *not* receive the dividend.
Ain't gonna happen.

It would be neat if you could buy a stock, short it, and still get paid the dividend. But unfortunately it doesn't work that way.

The real question I have is: do the insurance companies truly use all of the alvailable funds generated by the fixed income securities to create these call spreads or are they skimming some of the income off the top? ... In my mind, that is a valid concern and as a consumer I have no way to find that out.
Doesn't matter, and is of no concern. Yu don't need to "find that out" because it is immaterial to you.
The contract says that the policy holder is paid based on what the index does. It says nothing about how the company invests the money. They could buy calls, they could buy gold, they could buy Mongolian yak milk futures. How they make their profit is their problem, not the consumer's. All the consumer cares about is that he gets paid what he is supposed to -- he doesn't care how the company got the money.
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