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Dividend arbitrage is a trading strategy that capitalizes on the discrepancy between dividend payouts and option pricing. It typically involves purchasing a stock and a corresponding put option before the stock’s ex-dividend date, allowing the trader to collect the dividend while hedging against potential losses in the stock’s value.
This approach is especially appealing when applied to low-volatility securities, as lower option premiums and predictable price movements enable traders to generate profits with minimal to no risk.
Understanding the mechanics of dividend disbursal is fundamental for executing dividend arbitrage strategies. Dividends are distributed in four stages, each critical to determining shareholder eligibility and timing for payouts:
To be eligible for the dividend, investors must buy shares at least two full business days before the record date. Those buying on or after the ex-dividend date will not qualify for the dividend. This timing aligns with the U.S. settlement cycle (T+2), ensuring shares are recorded in the buyer’s name. The same T+2 settlement cycle applies in Taiwan, making the process consistent across both markets.
Event-driven arbitrage refers to a broad category of investement strategies, while dividend arbitrage and dividend capture are specific strategies with varying approach and focus:
Event-driven arbitrage targets profit opportunities from corporate events such as mergers, acquisitions, spin-offs, etc. The execution method will differ depending on the specific events that the traders focus on.
For instance, while dividend arbitrage can be considered a type of event-driven strategy, it focuses specifically on the pricing inefficiency between a stock and its options around the ex-dividend date. On the other hand, dividend capture aims to benefit directly from dividend payments themselves.
As such, each of these strategies has varying execution methods and risk levels. The table below showcases a summary of their key differences:
Strategy | Event-Driven Arbitrage | Dividend Arbitrage | Dividend Capture |
Goal | Profit from discrepancies caused by corporate events | Profit from price discrepancies using options and the dividend | Capture the dividend payment |
Focused Events | Mergers, acquisitions, bankruptcies, restructurings, etc. | Ex-dividend date | Ex-dividend date |
Method | Depends on the specific event. | Simultaneously buying the underlying stock and put options before the ex-dividend date. | Buy stock before the ex-date to receive the dividend and then sell it shortly after. |
Risk Level | Depends on the specific event. | Lower risk (hedged with put options) | Higher risk (unprotected against price drops) |
If you need more resources to understand diverse trading methods, you can read our articles below for deeper insights:
Dividend arbitrage trades are executed through the following process:
1. Buying a Dividend-Paying Stock
The trader purchases shares of a dividend-paying stock before the ex-dividend date. This ensures eligibility to receive the declared dividend, as ownership is recorded before the cutoff.
2. Purchasing In-the-Money (ITM) Put Options
Simultaneously, the trader buys an ITM put option for the same stock in equal amounts. The put option will give the holder the right to sell the stock at the strike price at the specified period, rather than its market price.
While some traders may consider at-the-money (ATM) or out-of-the-money (OTM) puts as dividend arbitrage options, ITM puts are often preferred as their strike price is higher than the current share price, allowing them to act as a hedge against potential price drops.
3. Collecting the Dividend Payout and Exercising the Put
On the ex-dividend date, the trader collects the dividend payout. Then, they can exercise the ITM put option if the stock price drops, selling the stock at its strike price to offset any loss.
To illustrate how dividend arbitrage works in practice, let’s examine two hypothetical examples. These examples will clarify the profit calculations and demonstrate how the strategy performs under different market conditions.
Source: Freepik
In this dividend arbitrage example, we will provide a basic walkthrough of this strategy.
For instance, Company ABC is trading at $60 per share and is about to pay a dividend of $1.20 per share. Also, ABC’s March $62.50 put options are trading at $2.00.
Here’s how the dividend arbitrage trade is executed:
Now, assuming the transaction fees such as brokerage commissions are $20, let’s calculate the profit. The general formula for profit in this scenario is:
In this case, the total cost is $6,220 ($6,000 for the stock + $200 for the options + $20 transaction fees). If the stock price stays below $62.50 after the ex-dividend date, the put option will have intrinsic value. The trader will probably exercise the option and sell the shares in March at the $62.50 strike price. This brings in $6,250 (100 shares x $62.50).
Therefore, the profit is $150 as calculated below:
For this dividend arbitrage example, we will demonstrate different outcomes based on stock price movements.
Assume Company XYZ is trading at $80 and pays a $1.60 dividend. Their June $80 put option is trading at $3.00 per share.
The trade is executed as follows:
The costs of this trade will also include $20 for transaction fees. Depending on the stock price fluctuations, the trader can choose whether or not they want to exercise the put option, as seen below:
Scenario 1: Stock Price Drops
If the stock price drops from $80 to $75 post-dividend, the trader can exercise the put option to sell the share at the $80 strike price.
The profit or loss for this trade is calculated as below:
Even though the put option offset the $5 decline in stock price, it was insufficient to cover the option costs, leading to a $160 net loss.
To avoid such situations, traders rely on sophisticated trading tools and real-time data, such as those from TEJ’s financial datasets, to access accurate figures and execute the strategies effectively.
Scenario 2: Stock Price Rallies
If the stock price rallies from $80 to $85 post-dividend, the trader may sell the stock at the higher market price instead.
Here is the profit or loss calculation for this trade:
In this case, the trader gains $340 in profits from the dividend and the stock price increase, which is partially offset by the cost of the put. Since the put wasn’t used, it will expire after June as specified in the contract.
Dividend arbitrage requires a deep understanding of market dynamics, thorough cost-benefit analysis, and strict compliance with regulatory frameworks. Overlooking these factors may turn a low-risk strategy into a costly endeavor. The key challenges and considerations include:
The cost of options depends significantly on implied volatility (IV). Higher IV can inflate option premiums, reducing the profitability of the strategy. If the time premium and IV are disproportionately high compared to the dividend payout, the arbitrage opportunity may diminish or disappear entirely.
True arbitrage opportunities represent market inefficiencies and are therefore fleeting. In efficient markets, these discrepancies are quickly identified and exploited by other traders seeking similar advantages. This causes prices to adjust rapidly. Hence, finding profitable dividend arbitrage setups requires diligent monitoring and quick execution.
Brokerage commissions, exchange fees, and other transaction costs can significantly cut down potential profits, especially for smaller trades. If not calculated carefully, these costs may even lead to loss which is why it requires rigorous financial analysis before proceeding.
Additionally, tax implications on dividends and capital gains may vary by jurisdiction, adding another layer of complexity to this strategy. These factors can make dividend arbitrage less suitable for beginner traders with limited capital.
Successful dividend arbitrage relies on precise timing and access to up-to-date data. These elements are essential for all aspects of this strategy, from identifying opportunities to evaluating risks and executing trades effectively.
As a trusted financial and economic data provider, TEJ offers high-quality quantitative data solutions for rigorous investment strategies. Beyond basic stock prices, our comprehensive dataset includes metrics like financial performance, company risk attributes, and broker trading information, empowering traders to make informed decisions based on accurate market conditions.
Moreover, TEJ is currently collaborating with renowned platforms, such as Eagle Alpha, Neudata, and Snowflake. With this, we offer broader access to our premium datasets for investors worldwide.
Explore TEJ’s quantitative data solutions and elevate your dividend arbitrage strategies.
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