Dividend arbitrage is quite a difficult concept to get your head around, it is an options trading strategy. When used correctly it can yield higher gains for traders who buy put options.
Dividend arbitrage strategies involve purchasing a stock with an upcoming dividend payment, then also buying the equivalent amount of put options for that same stock. This is meant to create a low risk trade by hedging the downside of a stock, while waiting for the dividend payment.
Many new investors buy dividend paying stocks before the ex-dividend date, receive the dividend, then sell the shares. What they are doing actually doesn’t gain them any profit because the share price is calculated to include the dividend before the ex-date (dividend-price), and without the dividend after the ex-date (ex-dividend-price). Meaning the shares lose value after the dividend has been paid. That’s when arbitrage comes in!
How does Dividend Arbitrage Work?
Arbitrage exists as a result of market inefficiencies, so it would not work if all markets were perfect. Luckily for us, most markets are not perfect.
This strategy focuses around a stocks ex-dividend date, the date at which shareholders become eligible to receive dividend payments for that period. There are 4 key dates you need to be aware of regarding dividends.
- Declaration Date: This is, as the name suggests, the date a company announces they will be issuing dividends to shareholders in the future.
- Ex-Dividend Date: This is the final day before the record date at which someone can become an eligible shareholder who is entitled to dividends.
- Record Date: Companies examine their shareholders, and only those who as registered shareholders as of the record date will be entitled to receive dividend payments.
- Payable Date: Simply the payment date, it marks the day dividends will actually be distributed to eligible shareholders.
So… Dividend arbitrage players buy dividend paying stocks and put options of the same stock in equal amounts just before the ex-dividend date.
A put option for those who don’t know, is a contract that gives the owner the right to sell a specific amount of a stock at a pre-determined price (Strike Price) within an allotted timeframe. Put option buyers are expecting the price of the stock to decrease in the timeframe. When a put option is profitable, it is referred to as ‘in the money’ (ITM).
When dealing with arbitrage, the put options that are bought are deep in the money. The investor collects the dividend on the ex-dividend date, then executes the put option to sell the stock at the pre-determined price.
This strategy is intended to provide protection against the price drop of the dividend stock. Usually the share price of a dividend stock will drop just after the dividend is paid, the put option in place hedges against the downside of the share price while waiting for the dividend to be paid.
For dividend arbitrage to work, the extrinsic value of the put option must be less than the dividend you stand to gain. We walk through this in an example below.
The Steps for Performing a Dividend Arbitrage Trade
The steps outlined here do not include any research tips or timeframes. This is to encourage our readers to complete their own research and learn along the way.
- Buy a dividend paying stock before the ex-dividend date.
- Buy a put option of the underlying stock that is equal in value to the number of shares you have purchased. These put options can be ‘in the money’, ‘out the money’, or ‘at the money’. The more in the money the option, the greater the hedge value.
- Once the ex-dividend date has passed and you have received your dividend, a drop in share price of the stock will increase the value of your put option.
- If the put option lands in the money, you should sell the shares at the put options strike price.
The option with closest expiry date will have the lowest time value and will also have the lowest premium. This means weekly options are commonly the best target for these trades.
Also you must understand, if the cost of the put option is more expensive than the dividend you stand to earn, the trade is not a dividend arbitrage opportunity.
We will go through an example of a good trade, and a bad trade.
Examples of Dividend Arbitrage Trades
Company ABC is trading at $90 per share, it pays a quarterly dividend of $2.
A put option with a strike price of $100 is selling for $11 per share (100 shares per contract) giving us an intrinsic value of $10 per share. It looks like the trader can enter this trade with almost zero risk, this is why.
We buy 100 shares at $90 per share, equating to $9,000. Then we purchase our put contracts at $11 per share, totalling 100 shares to $1,100. Our total cost of this trade is $10,100.
Once we have received our dividend we exercise our put option at $100 per share, and we sell our shares after the small decrease once the dividend is paid, estimated at $88 per share. Our total gain is $10,200.
The calculated gain goes like this:
- Shares sold at $88 per share = $8,800
- Put options exercised at $100 per share = ($100 – $88)*100 = $1,200
- Dividend received = $200
So the $10,200 gain from the sale of the shares and put option, minus the $10,100 cost of the trade equates to a $100 risk free profit.
To evaluate whether a dividend arbitrage trade is worth it, the extrinsic value of the put option must be lower than the dividend paid.
In this example, the cost of the put option was $11 per share with an intrinsic value of $10 per share ($100 – $90). The extrinsic value is hence $11 – $10 (cost – intrinsic value) = $1, which is less than the $2 dividend paid per share.
Company XYZ is currently trading at $50 per share, and is paying a $1 dividend per quarter.
A put option with a strike price of $55 is selling for $8.50 per share, with an intrinsic value of $6 per share. Let’s see if this trade is worth placing.
If we estimate that once the ex-dividend date has passed the share price will drop by the dividend amount as usual, at the time we would execute the option, the share price would be $49 per share. From 100 shares we stand to make:
- Dividend of $100
- From the put option we would gain $600
- From the sale of shares after the dividend payment we would gain $4,900
- Total gain = $5,600
However, the costs:
- 100 shares bought at $50 per share = $5,000
- Cost of put option contract (100 shares) = $850
- Total cost = $5,850
If you were to place this trade you would lose $250 overall.
An easier way to calculate this is to use the formula in the last example:
- Dividend > (Cost of option contract – Intrinsic Value of option)
The dividend per share we stood to gain was $1, the cost of the option was $8.50, and in the intrinsic value of the option was $6. So $8.50 – $6 = $2.50 which is larger than $1 unfortunately.
Takeaways form Dividend Arbitrage
Dividend arbitrage trades are very hard to come by. Even though the market has trends such as a reduction in price after a dividend is paid, the price can move for a multitude of different reasons.
Also this strategy is more likely to be viable in low volatility conditions, which impact the price for short term options.
Before diving in, we talked a lot about the dividend and how it affects the trade, but you must evaluate the option first. If the put option is not the right trade for a stock, even if they pay a huge dividend, you could be putting more money at risk.