Dividend Spread Arbitrage
- A call gives the holder the right, but not the obligation, to buy a specific security for a set price, called the strike or exercise price.
- A call contract is usually for 100 calls, so it gives the holder the right to buy 100 shares of stock at the strike price.
- Intrinsic Value of Call = Current Stock Price – Strike Price of Call,
if the Difference > 0; else Intrinsic Value = 0.
- Dividend spread arbitrage is a form of risk arbitrage that takes advantage of the rise in stock and call prices right before the ex-dividend date (aka ex-date) and the decline in prices on the ex-date.
- When a company is about to pay a dividend, its stock and call prices usually climb right before the dividend is paid, then declines on the ex-dividend date.
- There are 2 methods of dividend spread arbitrage. Both require the use of calls options with little time value and low trading costs.
- Calls will peak, along with the stock, sometime before the ex-date. Sell calls short while the price is high, then close out the position on the ex-date.
- If enough call holders, anticipating the drop in price on the ex-date, sell before the ex-date and the call price declines below its intrinsic value, then buy the call, exercise it to receive the stock and the dividend, then sell the stock at its reduced price, or keep it if you anticipate further price increases.
Dividend spread arbitrage takes advantage of what happens when a company is about to pay a dividend:
- Its stock price, and therefore calls based on the stock, usually climbs right before the dividend is paid.
- Soon-expiring call holders, anticipating that the drop in price on the ex-date, start selling the day before in large numbers, possibly depressing the call price so that the call premium is less than its intrinsic value plus the dividend.
- Stock price and its calls decline to a local minimum on the ex-date, which is the date that the stock trades without the dividend.
How The Dividend Is Paid and How It Affects the Stock Price
When the board of directors declares a dividend, which is on the declaration date, they also specify the date of record and the payment date. The date of record is the date when a stockholder must be a registered owner of the stock—a holder of record—to receive the dividend. The payment date is when payment is actually made—generally about 3 weeks after the date of record.
Because it takes 3 business days to settle a stock trade, the date of record determines the ex-dividend date, which is 3 business days earlier. The ex-dividend date (aka ex-date) is the 1st day in which the stock trades without the recently declared dividend. An investor who buys the stock that settles on or after the ex-dividend date will not be entitled to the recently declared dividend.
The price of the stock increases steadily until the date of record, then drops by the approximate amount of the dividend on the ex-dividend date. The run-up in price occurs because investors are willing to pay more if they are expecting to receive the dividend, which offsets the increased price. The price declines on the ex-dividend date because the company's book value has decreased by the amount of the paid-out dividend.
Since in-the-money calls generally move with the stock price, they, too, will rise before the ex-date, then decline on the ex-date. Since many traders anticipate the price drop in the calls, many will sell their calls on the day before the ex-date, especially options that will expire soon afterward.
Moreover, open buy and stop sell orders are also usually reduced by the dividend amount on the ex-dividend date.
How the Dividend Spread Arbitrage Works
There are 2 possible ways to make money using calls on stocks that are about to pay a dividend. Both of these strategies require the use of in-the-money options with little time value. Whether these opportunities arise at a particular time depends on multiple variables that are not really predictable. One can only watch the market in real time to see if the conditions are right. But even if the right conditions do occur, only traders, such as dealers or floor traders, will very low trading costs will probably be able to profit from the low price differentials that may occur. Furthermore, reasonable profits could only be made by trading a large number of call contracts.
The 1st opportunity will probably occur a couple of days before the ex-date, when both the stock price and its underlying calls are peaking in price. After the calls decline on the ex-date, the trader closes out his position by buying the calls back.
The 2nd opportunity may arise when call holders, anticipating the drop in the call price on the ex-dividend date, sell in such large quantities right before the ex-date, that the calls are being sold at a slight discount to the stock. In other words, the price of the call plus its exercise price may become less than the underlying stock plus the imminent dividend payment. Hence, a small profit can be made by buying the call, then exercising it to receive the stock and the dividend, then selling the stock at its reduced price on the ex-date.
For instance, suppose a call with a strike price of $40 for XYZ stock, currently selling for $50, and that is about to pay a $1 dividend, is selling for $9.80 right before the ex-date. A trader with low transaction costs could buy the call, exercise it, then collect the $1 dividend. If the trader sold the stock the next day at its reduced price of $49, the trader still comes out ahead by 20 cents per share minus his trading costs. If his trading costs are 10 cents a share that leaves a profit of 10 cents a share.
There is some risk that the trader will be assigned an exercised call on his short position, but the trader can just satisfy the exercise by giving some of the stock that he already owns from his exercised calls.
Dividend spread arbitrage is risk arbitrage, because there are potential losses, depending on market conditions and trading costs.