Dividend Arbitrage

The Opportunity - If a company is paying dividends, the Collar strategy can be used to capture the dividends risk free. Here is how.

The Collar - A few days before the ex dividend date, we buy the stock, and buy a put option, and sell a call option of the same strike price and with the same expiration date. The income from selling the call must be equal to or higher than the cost of our put option.

If the call premium is less than the put cost, we can use a trend to compensate the difference. At the beginning of an uptrend, we buy the stock first, as the uptrend ends, we buy the put and sell the call. Alternatively, at the beginning of a downtrend, we buy the put and sell the call first, as the downtrend ends, we buy the stock. This must be done at the same day to avoid overnight risk.

Once-a-Month Opportunity - Dividends are paid quarterly. A company that pays 10% dividend annually will pay 2.5% per quarter. We select companies that pay dividends over 2.5% per quarter in three months of a quarter, we can earn 2.5% risk free every month. An annual return of 30% is possible if the stock is not called away.

Dividend-Rich Stocks

Some stocks pay dividend over 20% per year.

Being Called

A study by Hao, Kalay and Mayhew (2006 ) proved that holders of American call options have an incentive to exercise options before the ex-dividend date (Roll, 1977 also confirmed that when the time value left with the call is less than the dividend announced, the call holders may exercise the option one day before the ex-dividend date). If the stock is called before the ex-dividend date, we will lose the opportunity of receiving the dividend. However, the put option will be ours free of charge, which will become profitable if the stock drops.

If we invest in stocks that pay 10% per year (2.5% dividend per quarter) once a month, and there is a 50% chance of being called the stock. Our annual return can be 15% or more.

Worse Scenario

The worse scenario is when the stock drops hard. We have to wait until the expiration date of our put to recover the loss. Before expiration, puts have less profit to cover loss from the stock due to delta which will be less than 1 before expiration. This means $1.00 decline in stock value, the put option will gain less than $1.00. Delta will become 1 at expiration.

Watch-Out! Corporate Special Dividend Adjustment

Companies that pay special dividends will adjust the strike prices of options. For example, Sep 13, 2010 was the ex-dividend date of PDLI which announced a special dividend of $0.50. On Sep 8, 2010, PDLI was trading at $5.72. The October 2010, $6.00 put was asking for $0.40. We established a position.

However, on the ex-dividend date, the stock dropped 0.50 and the strike price of our put option was down 0.50, now we were holding a 5.50 strike put, resulting in a loss on the stock and a loss on the put option. And we had to pay tax on the dividend received!

In other words, the strike price of a put option can be adjusted lower for special dividends, resulting in a loss from the put option.

Bi-Directional Model

We trade the same asset long and short at the same time automatically.

Algorithmic Collar

We actively trade the underlying stock with a collar.

0-Risk Dividend Arbitrage

  • We foud opportunities in 0-risk dividend arbitrage.


Risk Disclosure

Investment involves risk. Hypothetical performance results have many limitations. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. One of the limitations of hypothetical performance trading results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading.