Dividend Arbitrage Strategy
Dividend arbitrage is a trading strategy designed to exploit price discrepancies that occur around dividend payouts. It typically involves the simultaneous purchase of a stock and a related option, usually a put option, prior to the stock’s ex-dividend date. The primary goal is to capture the dividend payment while hedging against potential price declines as the stock trades ex-dividend.
Key Elements of Dividend Arbitrage
Ex-dividend Date
The ex-dividend date marks the point when a stock starts trading without the right to the upcoming dividend.
To be eligible for the dividend, the stock must be purchased before this date.
Dividend Capture
The core principle involves buying the stock before the ex-dividend date to receive the dividend.
After the dividend payout, the investor may sell the stock or continue to hold it depending on market conditions.
Hedging with Put Options
Put options provide downside protection if the stock price drops after the dividend is paid.
Purchasing a put option simultaneously helps mitigate the risk of price volatility.
Risk Considerations
While dividend arbitrage tends to be lower risk, particularly with low-volatility stocks, it is not without risks.
Investors must consider:
Price fluctuations after the ex-dividend date.
The cost of options premiums and commissions.
The possibility the stock price could fall more than the dividend amount, impacting net gains.
Why Low-Volatility Stocks?
These stocks often have more predictable price movements.
Lower volatility tends to result in cheaper option premiums.
This combination makes dividend arbitrage financially attractive and less risky.
Practical Example
Consider a stock priced at $50 with a $2 dividend payable next week.
A put option with a $50 strike price expiring after the ex-dividend date might trade at a certain premium.
An investor purchases the stock and the put option before the ex-dividend date.
After receiving the $2 dividend, they have the flexibility to:
Sell the stock, potentially exercising or benefiting from the put option if the stock price dropped.
Hold the stock for longer-term gains.
Summary
Dividend arbitrage exploits temporary price adjustments around dividend distributions by combining stock purchases with hedging strategies such as put options. This approach allows investors to capture dividends more safely in low-volatility environments, balancing potential profits with protective measures against price decline. Understanding the timing, costs, and risks involved is crucial for successful implementation.