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.
- 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.
- 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.
- 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.
- The third stage is the ex-dividend date, typically set two business days prior to the record date.
- 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.