Dividend Arbitrage is buying a stock before the ex-dividend date and selling an equivalent amount of the underlying’s stock futures or buy a put after the ex-dividend date.The strategy is used by arbitrageurs to purchase put options and proportionate number of stock before the ex-dividend date. The next step is to wait till the dividends are paid, and then exercise the put after collecting the dividend. The profit is the difference between dividends received and total value of put options bought.
The stock that pays the dividend would rise before the dividend is paid, and then declines overnight as the stock goes ex-dividend date. The arbitrageurs will not benefit by just buying the stock for a dividend because you lose in stock price what you gain in dividend payment. Be sure to buy the puts with extrinsic value lower than the dividends receivable.
Dividend Arbitrage Example
Suppose a company ABC is trading at $30 and announced a dividend to investors with a value of $1 per share in one week’s time. A put contract of the company is trading at $2.25 with one month expiry at a strike price of $32.
The trader purchases 100 shares at the price of $3000 and a contract for $225. The net investment is $3225. In a week, the dividend of $100 is paid. Trader will exercise the put option at $3200. The total earning will be $3300, for a profit of $75.
1. Stock Price: $30
2. Dividend: $1
2. Strike Price: $32
3. Put Contract Price: $2.25
4. Dividend Expiry Date: 7 days
Total Investment: $30 * 100 shares + $225 (a put option contract)
Total Earning= $100 (total dividend) + $3200 (selling put option)
Profit= Earning -Investment= $75
Important points to remember for Dividend Arbitrage:
1. Strike or Exercise Price: The strike price of an option will give the buyer the right to buy or to sell a specific amount of stock for a predetermined price.
2. Call Option: A Call Option is security that gives the owner the right to buy a stock, bond, commodity, index or other instrument at a specified price by a specified time period.
3. Put Option: An Put Option is security that gives the owner the right to sell a specified amount of an underlying security at a specified price by a specified time period.
4. Ex-dividend Date: The ex-dividend date is the date up to which you need to hold the stock in order to be entitled to receive the dividend. Ex-dividend is the time period between the announcement and payment of a dividend.
4. Option Contract: The contract gives to the option holder the right to buy or sell a particular asset at a specified price by a specified time period. Options contracts are used in securities, commodities, and future market. One option contract represents one hundred shares in the underlying stock.
5. Intrinsic Value: Intrinsic value is define as exercising the option at its strike price and then liquidating the stock position at the current market price of the stock.
Intrinsic Value = Market Price – Strike Price
6. Extrinsic Value: Extrinsic value is the value of the option before it expires. Extrinsic value depends on the strike price, time, volatility, and demand.
Extrinsic Value = Option Value – Intrinsic Value
7. Expiry: The last date on which an option contract can be exercised.
8. Assignment: A notice by an option writer to sell the security in the case of a call option, or to buy the security in the case of a put option at a specified price by a specified time period.
9. Dividend: A dividend is the share of the profit that a company decides to distribute to its shareholders in proportion to their holdings. The dividend can be in form of cash, stock, property, interim and others.
10. Option Premium: The premium is defined as the price that we pay for the purchase of the option contract or the amount of money which we receive when we sell the option contract.
Option Premium= intrinsic value + extrinsic value