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 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 intendedto create a risk-free (or low-risk) profit by hedging the downside of adividend-paying stock while waiting for upcoming dividends to be issued.
Understanding Dividend Arbitrage
To understand this concept, it helps to know some basics on arbitrage and dividend payouts.
Generally speaking, arbitrage exploitsthe price differences of identical or similar financial instruments on different markets for profit. It exists as a result of marketinefficienciesand would not exist if themarkets were all perfectly efficient.
How Dividends Are Disbursed
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.
- Declaration date: The declaration date is the date on which the company announces that it will be issuing a dividend in the future.
- Record date: The record date 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.
- Ex-dividend date: The ex-dividend date is typically set two business days prior to the record date.
- Payable 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.
How to Use Dividend Arbitrage
In a dividend arbitrage play, a trader buys the dividend-paying stock and the 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 intendedto create a risk-free profit by hedging the downside of adividend-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 willnotprovide the same results as when combined with the purchasing of puts.
Dividend Arbitrage Example
To illustrate how dividend arbitrage works, imaginethat stock XYZABCis 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.
Can I Buy a Stock Just Before the Dividend?
Yes, you can buy a stock just before the dividend is paid out and collect that dividend. You must buy at least one day before the ex-dividend date in order to be a shareholder on record when the dividend is paid.
Is Dividend Arbitrage Illegal?
Using a dividend arbitrage strategy isn't illegal. It's simply one of the ways traders attempt to optimize their profits while minimizing their risks.
Can You Lose Money With Dividend Arbitrage?
No trade is perfectly risk-free. Two main considerations that affect the profits you take with a dividend arbitrage strategy are taxes and trading costs (including options premiums). Make sure you fully understand the mechanics of this strategy before you implement it.
The Bottom Line
With dividend arbitrage, you buy put options and an equivalent amount of underlying stock before its ex-dividend date and then exercise the put after collecting the dividend. The puts are intended to provide protection against the stock's drop in price before the dividend payout, so the trader risks less than they would with a pure dividend capture strategy.
