Dividend Spread Arbitrage with Example
It is important to understand the definition of dividend arbitrage before going into details.
Dividend arbitrage is a strategy used in options trading. The trader purchases an equivalent amount of underlying stock and put options before the ex-dividend date and then exercises the put after collecting the dividend.
When this strategy is used on low volatility and a high dividend, it can result in a profit, and more importantly, with very low to no risk. So, now we will discuss dividend spread arbitrage works.
In this article, we will be discussing dividend spread arbitrage with example.
How Dividend Arbitrage Works
It is important to understand the basics of dividend payouts and arbitrage.
The concept is simple because arbitrage utilizes the price difference between similar or identical financial instruments on different markets to make a profit. It helps to make a profit by utilizing market inefficiencies. If everything is perfectly efficient in the markets, then you can’t make money with dividend arbitrage.
Four stages are involved in dividend disbursal. Let’s have a look at all these stages one by one.
- The first stage is the declaration date. Generally, it is the date on which the company will be issuing a dividend in the future.
- The next stage is the record date. On this date, the company checks the list of shareholders to find out who will receive dividends. Only those people who are registered as a shareholder in the company’s list are eligible to get a dividend.
- The next stage is the ex-dividend. It is the key date as it will decide which shareholders are going to be paid dividends. Typically ex-dividend date is set two business days before the record date.
- The final stage is the payable date. It is also referred to as the payment date. It is the date on which dividend is disbursed to the eligible shareholders.
In simple words, if you want to get a dividend, you will have to be a stakeholder of a record. Make sure that you are part of it before the record date. You would be eligible to get dividends if you had owned shares at least two business days before the record date was set.
When traders want to get the benefit of dividend spread arbitrage, they buy the put options and dividend-paying stock before the ex-dividend date. The strike price of put options is above the current share price; that’s why put options are deep in the money. Options trader collects his dividend on the ex-dividend date and then exercises his put option. He sells his stock at the put strike price.
The purpose of dividend arbitrage is to create a risk-free profit. In case, the stock price drops before the dividend was paid and it mostly happens, then purchased puts provide protection. So, if you are buying stocks for just dividend income, it might not work well until it is combined with the purchasing of puts.
Dividend spread arbitrage Example
These examples will help you to understand the concept of dividend arbitrage. For example, an ABC stock is trading at $50 per share, and it is paying $2 dividend in one week.
A put option that has an expiry of three weeks and a strike price of $60 is selling for $11.
So, if a trader wishes to enjoy dividend arbitrage, he can purchase a single contract in $1100 and 100 shares for $5,000 for a total cost of $6100.
If a trader sells a stock for $6000 in one week, he will get $200 in dividends. He will earn $6200 by selling stock and dividend, and the profit will be $100 without fees and tax deduction.
When to Use Dividend Spread Arbitrage?
You can use it just before the ex-dividend date to get stock’s dividend. Make sure the cost of hedging is significantly lower than the dividend that is expected to be declared. You can get most out of dividend arbitrage when the expected dividend is more than the extrinsic value in the money.
- Dividend arbitrage is a form of risk arbitrage and using this, you can take advantage of the rise in stock prices right before the ex-dividend rate and also decline in the ex-dividend date’s prices.
- When a company is going to pay a dividend, its call and stock prices usually gets higher before the dividend is paid, and then the prices decline on the ex-date.
- You can take advantage of dividend spread arbitrage in two methods, such as by the use of low trading costs and call options with little time value.
How Dividend Affects Stock Price
When a dividend is declared by the board of directors on the declaration date, they also declare the record date and payment date. Record date specifies the eligibility of a trader to receive dividends. Typically the payment date is after three weeks of the record date.
The stock price moves steadily until the date of the record, and it declines by an approximate amount of the dividend on the ex-dividend date. If the investors are willing to get dividends soon, they pay more for it, and price run-up.
The Disadvantage of Dividend Arbitrage
It isn’t easy to spot the dividend arbitrage opportunities because the price discrepancies are filled quickly. Dividend arbitrage becomes difficult for amateur traders because broker commissions are high.
Dividend spread arbitrage is an options trading strategy in which put options are purchased before the ex-dividend rate.
If you can execute it well, it can result in a decline in stock prices, and you can get more dividends. More importantly, it is a low-risk way of making a profit. Moreover, dividend arbitrage is going to work in an environment where the volatility is low. So, it isn’t easy to find true dividend arbitrage because markets are full of traders, and everyone is looking for opportunities.
If you want to enjoy the benefits of dividend arbitrage, you must understand its basics. You can get most out of options trading by using effective strategies and varying your strategies from time to time. If you can grab the opportunity, you can make risk free profit.
Sky Hoon. Read Full Bio
Website Owner, Twitter-er
He has been trading since 2008. He started this blog to share the journey about option trading. He dabbled in stocks, bitcoin, ethereum (in Celsius Network), ETF (lazy Dollar Cost Averaging) and also built websites for fun. He used this as a platform to share my experiences and mistakes in trading, especially options which I just picked up.