Dividend Arbitrage

Dividend Arbitrage - Definition

Dividend Arbitrage is an options arbitrage strategy which makes a risk free profit through the difference between dividends received and premium paid on a put protected stock position.

Dividend Arbitrage - Introduction

You need a comprehensive knowledge of options arbitrage before you can fully understand Dividend Arbitrage.

Dividend Arbitrage is a method of locking in a portion of the dividends paid by a stock risk-free by hedging against a drop in the underlying stock using in the money put options. The problem with dividends is that the price of the underlying stock normally drops by the value of the dividend declared during ex-dividend day. This drop could be significant when a company declares a big dividend and dividend arbitrage is used for locking in some of the dividends without any directional risk posed by the stock price.

How Does Dividend Arbitrage Work?

Dividend arbitrage makes a risk-free profit by completely hedging a dividend paying stock from downside risk while waiting for the dividends to be paid. Once dividend is paid, the position is dissolved, reaping the difference between the amount paid for the hedge and the dividend received.

Stocks paying dividends would normally decline by an amount equal to the dividends paid during ex-dividend day, the final trading day when owning the stock entitles the holder to the dividends payable. As such, receiving the dividends merely create a net zero situation if the stock pays out dividends immediately following ex-dividend day. To make matters worse, some stocks pay out dividends days or weeks after ex-dividend day, exposing the owner of the stock to significant downside risk of owning the stock. In order to receive the benefits of receiving the dividends without any of the downside risk of holding the stock, the stock position must be hedged. This is done by buying in the money put options with extrinsic value significantly lower than the dividends receivable to protect the stock from downside risk. As long as the cost of hedging is lower than the dividends received, a risk-free profit situation arises.

Read about the Effects of Dividends on Stock Options.

The problem with dividend arbitrage, like all arbitrage strategies, is that arbitrage conditions rarely exist long enough for most retail options traders to identify and take advantage of. In the case of dividend arbitrage, the situation where the cost of hedging (extrinsic value of put options + commissions) is lower than the dividends receivable is very rare because the dividends payable would have been announced many weeks prior to ex-dividend day which would then be priced into its put options, typically increasing their extrinsic value beyond the dividends receivable.

When To Use Dividend Arbitrage?

Just before a dividend paying stock's ex-dividend day. The cost of hedging must be significantly lower than the dividend that is expected to be declared. Dividend arbitrage opportunity exists when expected dividends is more than the extrinsic value of the in the money put options to be bought and commissions involved.

How To Establish Dividend Arbitrage?

Dividend arbitrage is set up by buying a stock just before ex-dividend day and then buying an equivalent number of in the money put options with extrinsic value lower than the dividends receivable.

Buy Stock + Buy ITM Put

The dividend arbitrage position is then held all the way until dividends are received. Once dividends are received, the put options are exercised and the stock is sold at the strike price of the put options at no loss except for the extrinsic value of the put options paid. Profit is made on the difference between the dividends recieved and extrinsic value of put options bought.

Dividend Arbitrage Example :

Assuming XYZ company's shares are trading at $51 and its March $55 Put is trading at $4.50 and its dividends payable is $1.00 per share.

Buy 100 shares of XYZ stocks and Buy to open 1 contract of March $55 Put.

Net debit = ($51 x 100) + ($4.50 x 100) = $5,550

Dividends of $1.00 per share is received for a total of $100 and then put options are exercised and the stock are sold for $5,500 at the strike price of the put options.

Since you made $100 on the dividends received and lost $50 ($5,550 - $5,500) on exercising the put options (which is the extrinsic value of the put options), a risk-free profit of $100 - $50 = $50 arises.

What Happens If The Stock Drops By the Time Dividends Are Received?
The in the money put options made sure that even if the stock should make a dramatic decline during the wait for dividends to be paid, no loss would be made on the decline in stock price due to the right to sell the stock at the strike price of the put options.

What Happens If The Stock Rallies By the Time Dividends Are Received?
Should the stock make a dramatic rally in price by the time the dividends are recieved, additional profits may arise. This only happens when the stock rallies significantly above the strike price of the put options bought.

Dividend Arbitrage Example 2:

Assuming XYZ stock in the example above rallies to $100 by the time dividends are recieved and the March55Put declined in value to $0.05.

Profit = (dividends received + gain in stock) - Loss in put options.

Profit = ($100 + [$10,000 - $5,100]) - ($450 - $5) = $5000 - $445 = $4,555

Profit Potential Of Dividend Arbitrage

A properly executed Dividend Arbitrage has zero chance of a loss. Arbitrage profit occurs when the stock remains below the strike price of the put options bought by the time dividends are received and additional profits may arise if the stock rallies strongly above the strike price of the put options bought.

Profit Calculation of Dividend Arbitrage :

Arbitrage Profit = Dividends - (Extrinsic Value of Put + Commissions)
(When stock remains below strike price)

Risk / Reward of Protective Puts:

Upside Maximum Profit: Unlimited
(When the underlying stock breaks out strongly to upside)

Maximum Loss: No Loss Possible

Advantages of Dividend Arbitrage

:: Able to obtain risk-free profits.

Disadvantages of Dividend Arbitrage

:: Dividend Arbitrage opportunities are extremely hard to spot as price discrepancies are filled very quickly.

:: High broker commissions makes Dividend Arbitrage difficult or plain impossible for amateur trader.

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