What is Dividend Arbitrage
Dividend arbitrage is an options trading strategy that involves purchasing put options and an equivalent amount of underlying stock before the 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 create profits while assuming very low to no risk.
BREAKING DOWN Dividend Arbitrage
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.
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, the puts that were purchased provide protection.
The ex-dividend date determines who receives the dividend that is about to be paid out. Following the ex-date, the price of shares should decline by the amount of the dividend being issued. 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.