Dividend Arbitrage Explained

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

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.

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.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

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.

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

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

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

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.

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?

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.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

Like this post? Please share to your friends:
How To Start Binary Options Trading 2020
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: