What is dividend arbitrage?
Dividend arbitrage is an options trading strategy that involves buying a put option and an equal amount of the underlying stock going ex-dividend and then exercising the put option after receiving the dividend. When used in securities with low volatility (resulting in lower option premiums) and high dividends, dividend arbitrage can lead investors to realize profits assuming very little or no risk.
KEY TAKEAWAYS
- Dividend arbitrage is an options trading strategy that involves buying a put option and the equivalent of the underlying stock before the ex-dividend date, and then exercising the put option after the dividend is collected.
- When used in securities with low volatility (resulting in lower option premiums) and high dividends, dividend arbitrage can lead investors to realize profits assuming very little or no risk.
- Dividend arbitrage is designed to create risk-free (or low-risk) profits by hedging against declines in dividend-paying stocks while waiting for an upcoming dividend.
Understanding dividend arbitrage
First, some basics about arbitrage and dividend payments. Generally speaking, arbitrage exploits the spread of the same or similar financial instruments in different markets to profit. It is the result of the market; inefficiency & if the market were all perfectly efficient, it would not exist.
The A-share ex-dividend date (or simply the ex-dividend date) is a key date in determining which shareholders are entitled to the upcoming dividend. This is one of four stages of dividend payments. 1
- The first stage is the filing date. This is the date on which the company declares future dividends.
- The second stage is the record date, that is, the company is reviewing its current shareholder list to determine who will receive the dividend. Only those who are registered as shareholders in the company’s books on the record date are entitled to dividends.
- The third stage is the ex-dividend date, which is usually set two business days before the record date.
- The fourth and final stage is the payment date. Also known as the payment date, it marks when the dividend is paid to eligible shareholders.
In other words, you must be a shareholder of stock on record not only on the record date but actually before it. Only shareholders who hold shares for at least two business days before the record date are entitled to dividends.
After the ex-dividend date, stock prices typically fall as dividends are paid.
Thus, in the dividend arbitrage game, traders buy dividend-paying stocks and an equal amount of put options before the ex-dividend date. Put options are deeply profitable (that is, their strike price is higher than 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 designed to hedge against the decline in stocks that pay dividends while they wait for an impending dividend. Put options, which are usually purchased, protect if the stock falls in price when the dividend is paid. Therefore, buying a stock dividend income alone provides different results than buying a put option;
Dividend Arbitrage Example
To illustrate how dividend arbitrage works, assume that XYZABC’s stock is currently trading at $50 per share and pays a $2 dividend in one week. A put option that expires in three weeks with a strike price of $60 sells for $11. A trader looking to construct a dividend arbitrage could buy one contract at $1,100 and 100 shares at $5,000 for a total cost of $6,100. A week later, the trader will receive a $200 dividend and a put option to sell the stock at $6,000. Total income from dividends and stock sales is $6,200, and pretax profit is $100.
