Q&A with McMillan: What is Dividend Arbitrage?

By Lawrence G. McMillan

A twitter follower recently inquired about extremely heavy option volume in a particular stock. I explained that it was due to dividend arbitrage. For those wondering, the following Q&A from a 2004 issue of The Option Strategist explains the intricacies of this professional-favored strategy. 

Customer:

You have repeatedly mentioned dividend arbitrage. Could you briefly tell me what it is? – J.Z., 1/17/2004

McMillan:

Dividend arbitrage has been around since listed call options first traded. It has become quite popular lately, though, as heavy call volume is noticeable in nearly every stock with decent open interest in its options that is paying a quarterly dividend of 20 cents or more.

Suppose XYZ is going ex-dividend 25 cents tomorrow, and that XYZ is trading at 38. Furthermore, suppose that there is large open interest in the Feb 30, 32.5, and 35 calls. A dividend arb could be established by buying a bull spread or selling a bear spread involving calls with any two of those three striking prices. Suppose the arb buys 100 Feb 30 calls and sells 100 Feb 32.5 calls for a 2.5 debit (he pays parity – the difference in the strikes). Once the position is bought, he immediately exercises his long calls to produce a covered write:

Long 10,000 XYZ and Short 100 XYZ Feb 32.5 calls

Now he waits for the next day, and he hopes that he will not be assigned on all of this short calls. Any covered writes that he does not get assigned on, he gets the 25 cent dividend on those shares. Obviously, every holder of the Feb 32.5 calls should exercise them to get the dividend, but they don’t always – and whatever goes unexercised (through oversight or whatever) – is a potential profit for the arb.

He then has to hold the stock through February expiration (unless he can unwind the position early – unlikely), hoping that the stock does not fall below his striking price (32.5) before then. Hence, arb positions established when expiration is nigh have less risk than those established with a few weeks to go until expiration. Note that he has to pay carrying costs (something like paying margin interest, if you’re familiar with buying on margin) to hold the position all the way until expiration, but at today’s low interest rates that is not a big cost – certainly far less than 25 cents.

This strategy is more amenable to professional traders because their transaction costs are nearly zero, so if they get assigned on the entire position, they only lose a little money. For customers, though, who might be thinking of attempting this strategy, one would have to figure in his commission costs vis-a-vis the probability of earning the dividend.

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