What is Dividend Arbitrage: Strategy, Process, & Examples

Dividend arbitrage focuses on the price inefficiencies between dividend payouts and option pricing. Discover its execution process, examples, and challenges

What is Dividend Arbitrage?

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. 

How Does Dividend Disbursal Work?

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:

  1. Declaration Date: This is the date when the company formally announces its decision to issue a dividend. The announcement typically includes details like the dividend amount, record date, and payment date.
  2. Ex-Dividend Date: At this point, the stock’s price is adjusted to reflect the removal of the dividend’s value. This date is usually set at two business days before the record date.
  3. Record Date: On this date, the company reviews its shareholder records to identify who will be eligible to receive the dividend.
  4. Payable Date: The actual payment date when the declared dividend is distributed to eligible shareholders.

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.

How is Dividend Arbitrage Strategy Different from Event-Driven Arbitrage and Dividend Capture?  

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 ArbitrageDividend ArbitrageDividend Capture
Goal Profit from discrepancies caused by corporate eventsProfit from price discrepancies using options and the dividendCapture the dividend payment
Focused EventsMergers, acquisitions, bankruptcies, restructurings, etc.Ex-dividend dateEx-dividend date
MethodDepends 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 LevelDepends 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:

How are Dividend Arbitrage Trades Executed?

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. 

Dividend Arbitrage Examples

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. 

Dividend arbitrage involves simultaneously buying a dividend-paying stock and its put options. On the ex-dividend date, the trader collects the dividend payout and then sells the stock at the strike price to offset losses from the depreciated market price.

Source: Freepik

Example 1

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:

  • Buy the Stock: The trader purchases 100 shares of ABC at $60, costing $6,000 (100 shares x $60/share).
  • Buy Put Options: Simultaneously, the trader buys one contract (covering 100 shares) of the March $62.50 put options for $200 (1 contract x 100 shares/contract x $2/share).
  • Collect the Dividend: On the ex-dividend date, the trader receives $120 in dividends (100 shares x $1.20/share).

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: 

  • Dividend Income – (Options Cost + Transaction Fees) + (Strike Price – Stock Cost)

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:

  •  $120 (dividends) – $6,220 (total cost) + $6,250 (stock proceeds) = $150

Example 2

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:

  • Buy the Stock: The trader purchases 100 shares of XYZ at $80, costing $8,000 (100 shares x $80/share).
  • Buy Put Options: At the same time, the trader buys one contract (covering 100 shares) of the June $80 put options for $300 (1 contract x 100 shares/contract x $3.00/share).
  • Collect the Dividend: The trader receives $160 in dividends (100 shares x $1.60/share) on the ex-dividend date.

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:

  • $160 (dividend) – $300 (options cost) – $20 (transaction fees) + $8000 (stock strike price) – $8000 (stock cost) = – $160

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:

  • $160 (dividend) – $300 (options cost) – $20 (transaction fees) + $8500 (stock market price) – $8000 (stock cost) = $340

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.

What are the Challenges of Dividend Arbitrage?

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:

Impact of Implied Volatility 

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. 

High Competition and Market Efficiency

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.

Costs and Tax Implications

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.

TEJ: Financial Data Solutions for Dividend Arbitrage Strategies

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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