Dividend arbitrage is a low-risk method of trading stocks that includes purchasing the put, or sell, option of a particular stock as well as the underlying stock itself, provided that stock is promised a dividend. When the date due for the dividend arrives, the trader then exercises his or her put option, collecting the price of the option. The trader will also collect the dividend on the stock, which, when added to the money gained on the option, should outweigh the price of the initial transactions. Having the stock and the put option in tandem takes away the risk of the stock's volatility doing damage to the trader.
A dividend is a payment made by a company to its investors. When a company announces a dividend, it announces a record date, which marks the last possible time for an investor to be on the company's books to qualify for the dividend. The exchange that handles the stock then sets an ex-dividend date, after which anyone purchasing the stock will not qualify for the dividend. Investors can use these dates and the dividend information to practice dividend arbitrage.
For example, the company behind stock A announces an upcoming dividend to investors with a value of $1 US Dollar (USD) per share. At the time this is announced, stock A is selling for $25 USD per share. The trader purchases 100 shares of the stock at a price of $2,500 USD. To execute dividend arbitrage, he or she then must purchase the equivalent value of the stock in put options to balance the transaction.
The investor in this example now buys one put contract on Stock A for $5.50 USD, paying out $550 USD in the process, at a strike price of $30 USD. When the stock goes ex-dividend, the investor will collect the dividend amount of $100 USD, then exercise the put option, gaining a total of $3,000 USD from the stock sale. This amount, added to the dividend collected, gives the investor $3,100 USD, which outweighs the original payout of $3,050 USD for purchasing the stock and the put option. Using dividend arbitrage, the investor has gained $50 USD at little risk.
By playing the stock from both sides, the investor is protected from an unexpected up or down move on the stock in the time between the two sets of transactions. Using the example above, there is the possibility that the price of Stock A could shoot up upon news of the dividend. While this would lessen the value of the investor's put option, he or she would be covered by the purchase of the stock.