Dividend Arbitrage Explained

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Dividend Arbitrage

This is an arbitrage strategy whereby the options trader buys both the stock and the equivalent number of put options before ex-dividend and wait to collect the dividend before exercising his put.

Example

XYZ stock is trading at $90 and is paying $2 in dividend tomorrow. A put with a striking price of $100 is selling for $11. The options trader can enter a riskless dividend arbitrage by purchasing both the stock for $9000 and the put for $1100 for a total of $10100.

On ex-dividend, he collects $200 in the form of dividends and exercises his put to sell his stock for $10000, bringing in a total of $10200. Since his initial investment is only $10100, he earns $100 in zero risk profits.

Dividend Capturing using Covered Writes

Another way to collect dividends is by using covered calls. This strategy is detailed in this article.

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Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

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Valuing Common Stock using Discounted Cash Flow Analysis

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Dividend Arbitrage

What is Dividend Arbitrage?

Dividend arbitrage is an options trading strategy that involves purchasing put options and an equivalent amount of underlying stock before its ex-dividend date and then exercising the put after collecting the dividend. When used on a security with low volatility (causing lower options premiums) and a high dividend, dividend arbitrage can result in an investor realizing profits while assuming very low to no risk.

key takeaways

  • Dividend arbitrage is a trading strategy that involves purchasing put options and stock before the ex-dividend date and then exercising the put.
  • Dividend arbitrage is intended to create a risk-free (or low-risk) profit by hedging the downside of a dividend-paying stock while waiting for upcoming dividends to be issued.

How Dividend Arbitrage Works

First, some basics on arbitrage and dividend payouts.

Generally speaking, arbitrage exploits the price differences of identical or similar financial instruments on different markets for profit. It exists as a result of market inefficiencies and would not exist if the markets were all perfectly efficient.

A stock’s ex-dividend date (or ex-date for short), is a key date for determining which shareholders will be entitled to receive the dividend that’s shortly to be paid out. It’s one of four stages involved in dividend disbursal.

  1. The first of these stages is the declaration date. This is the date on which the company announces that it will be issuing a dividend in the future.
  2. The second stage is the record date, which is when the company examines its current list of shareholders to determine who will receive dividends. Only those who are registered as shareholders in the company’s books as of the record date will be entitled to receive dividends.
  3. The third stage is the ex-dividend date, typically set two business days prior to the record date.
  4. The fourth and final stage is the payable date. Also known as the payment date, it marks when the dividend is actually disbursed to eligible shareholders.

In other words, you have to be a stock’s shareholder of record not only on the record date but actually before it. Only those shareholders who owned their shares at least two full business days before the record date will be entitled to receive the dividend.

Following the ex-date, the price of a stock’s shares usually declines by the amount of the dividend being issued.

So, in a dividend arbitrage play, a trader buys the dividend-paying stock and put options in an equal amount before the ex-dividend date. The put options are deep in the money (that is, their strike price is above the current share price). The trader collects the dividend on the ex-dividend date and then exercises the put option to sell the stock at the put strike price.

Dividend arbitrage is intended to create a risk-free profit by hedging the downside of a dividend-paying stock while waiting for upcoming dividends to be issued. If the stock drops in price by the time the dividend gets paid—and it typically does—the puts that were purchased provide protection. Therefore, buying a stock for its dividend income alone will not provide the same results as when combined with the purchasing of puts.

Example of Dividend Arbitrage

To illustrate how dividend arbitrage works, imagine that stock XYZABC is currently trading at $50 per share and is paying a $2 dividend in one week’s time. A put option with an expiry of three weeks from now and a strike price of $60 is selling for $11. A trader wishing to structure a dividend arbitrage can purchase one contract for $1,100 and 100 shares for $5,000, for a total cost of $6,100. In one week’s time, the trader will collect the $200 in dividends and the put option to sell the stock for $6,000. The total earned from the dividend and stock sale is $6,200, for a profit of $100 before fees and taxes.

Arbitrage

What is Arbitrage

Arbitrage is the purchase and sale of an asset in order to profit from a difference in the asset’s price between markets. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms. Arbitrage exists as a result of market inefficiencies and would therefore not exist if all markets were perfectly efficient.

BREAKING DOWN Arbitrage

Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market at a higher price, thus considered to be risk-free profit for the trader. Arbitrage provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. With advancements in technology, it has become extremely difficult to profit from pricing errors in the market. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly, and the opportunity is often eliminated in a matter of seconds. Arbitrage is a necessary force in the financial marketplace.

To understand more about this concept and different types of arbitrage, read Trading the Odds With Arbitrage.

A Simple Arbitrage Example

As a simple example of arbitrage, consider the following. The stock of Company X is trading at $20 on the New York Stock Exchange (NYSE) while, at the same moment, it is trading for $20.05 on the London Stock Exchange (LSE). A trader can buy the stock on the NYSE and immediately sell the same shares on the LSE, earning a profit of 5 cents per share. The trader could continue to exploit this arbitrage until the specialists on the NYSE run out of inventory of Company X’s stock, or until the specialists on the NYSE or LSE adjust their prices to wipe out the opportunity.

A Complicated Arbitrage Example

Though this is not the most complicated arbitrage strategy in use, this example of triangular arbitrage is more complex than the above example. In triangular arbitrage, a trader converts one currency to another at one bank, converts that second currency to another at a second bank, and finally converts the third currency back to the original at a third bank. The same bank would have the information efficiency to ensure all of its currency rates were aligned, requiring the use of different financial institutions for this strategy.

For example, assume you begin with $2 million. You see that at three different institutions the following currency exchange rates are immediately available:

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