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Summary
- Under dividend arbitrage, an investor longs a stock ahead of its ex-dividend date and then shorts an equivalent number of stocks ex-dividend.
- The arbitrage strategy is applied to a stock with low volatility and high dividend.
- The strategy is used as a hedge against the fall in stock prices after the company’s dividend distribution.
Dividend arbitrage is an options trading strategy where an investor longs a stock ahead of its ex-dividend date and then shorts an equivalent number of stocks via put options after collecting the dividend.
The arbitrage strategy is applied to a stock with a high dividend and low volatility (lower options premium). This arbitrage can lead to profits for an investor at a low or no risk. It can also be said that the strategy helps investors hedge against the fall in stock prices after the distribution of the dividend by the company. So, the dividend arbitrage strategy provides an opportunity to obtain risk-free profits.
Source: © Mb2006 | Megapixl.com
READ MORE: How do I start trading penny stocks in Australia?
However, dividend arbitrage may not be easy to execute. Here are the two key reasons:
- A dividend arbitrage strategy is best executed only if volatility is low in the market. If the implied volatility and time premium is too high compared to the dividend, the trade cannot be said to be ‘dividend arbitrage’.
- An arbitrage can only be termed as true arbitrage if there is an inefficiency in the market. Such opportunities are not in plenty since other traders are also eyeing opportunities to make money with the lowest possible risk. It is tough to spot as price discrepancies get filled very quickly.
How to use the dividend arbitrage strategy?
The strategy should be used just before the stock’s ex-dividend day. You should clearly understand that the strategy would work only if the cost of hedging is significantly lower than the expected dividend.
A dividend arbitrage opportunity exists when expected dividend is more than the extrinsic value of ‘in-the-money’ put options to be purchased and commissions involved.
Suppose a stock is trading at AU$90 and is scheduled to pay AU$2 in dividend the next day. A with a striking price of AU$100 is selling for $11. The trader can use dividend arbitrage by buying both the stocks for AU$9000 and the put option for $1100, amounting to AU$10100.
He collects a total of AU$200 (via dividends) on ex-dividend and now exercises his put option to sell his stock for AU$10000, bringing in AU$10200. He now earns AU$100 in zero-risk profit since his initial investment is AU$10100.
Source: © Moth | Megapixl.com
READ MORE: Which are the top dividend stocks in Australia?
How much profit can be expected?
According to experts, there is zero likelihood of a loss in the case of a properly executed dividend arbitrage. The arbitrage profit is realised when the stock is below the strike price of the put options purchased. An additional profit may be realised if the stock surges significantly above the strike price of the put options purchased.
READ MORE: How are Laybuy shares performing? Does the Company pay dividend?
Profit calculation
Arbitrage Profit = Dividends - (Extrinsic value of Put + Commissions)
(When stock price remains below strike price)
Source: © Moth | Megapixl.com
Do investors use dividend arbitrage strategy in Australia?
While the ordinary Australian investors use the strategy to purchase shares ahead of the stock’s dividend date and then sell them ex-dividend, deliberate manipulation arrangement by a company to avoid tax is addressed by anti-avoidance provisions of Part IVA the Income Tax Assessment Act 1936. For ordinary investors, the dividend income and capital loss are the same as for any other investment.
