Grab a peanut butter sandwich. I'm gonna teach you the Dividend Arbitrage strategy in @10kdiver's style ;-)

Arbitrage = Free Lunch in market. Free lunches usually don't exist, but they do exist, if you know where to look.

What amateur traders/investors think:

"Oh, this company has announced dividend. Let me buy the stock so that I can receive the dividend. I'll sell the stock just after the requisite date until which I should hold the stock. I'll then pocket the dividend. Free money yay!"

What happens:

The stock price rises leading up to the ex-dividend date, and then falls. You get the dividend, but the stock you hold falls in price equivalently. So, you're left with no profit, and if you're lucky, no loss either.

What are dividends?

Whenever a company has made good amount of profits, and feels generous enough to share the profits with the shareholders, they call that a dividend.

It's usually a percentage of net profits.

Four dates to be aware of:

1. Declaration date: When the company announces that it will be issuing a dividend in the future.

2. Record date: Date on which the company examines its current list of shareholders to determine who will receive dividends.

Only those who are registered as shareholders in the company’s books on record date will be eligible to receive dividends.

3. Ex-Dividend Date: It takes 2 business days to settle a stock trade. The date of record determines the ex-dividend date, which is 2 business days earlier.

The ex-dividend date (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 eligible to receive the recently declared dividend.

4. Payable date: This date marks when the dividend is actually distributed to the eligible shareholders.

This is usually 3 weeks after the record date.

So, what is the basis for the dividend arbitrage strategy?
Does this strategy work always? Nope. Not always. It's definitely hard to find a situation where this works.

But when it does work, it rewards you handsomely. So, it's definitely a good tool in your trading arsenal.

What happens when a company announces dividend?

- People usually crowd up to buy the stock anticipating the dividend
- The price of the stock increases until the date of record,
- Then the price 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 soon, 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 dividend paid.

The ITM calls move with the stock price. In the above scenario, they will rise before the ex-date, then decline on the ex-date.

Traders anticipating the price drop for their calls will sell on the day before the ex-date, especially calls expiring soon (current week or month).

Two ways to play this in the market.

1. Using Put options:

- Buy a dividend-paying stock before the ex-dividend date.

- Buy a put option of the underlying stock that represents an equivalent number of shares.

These options can be ITM, ATM or OTM. The more ITM the option is, the greater its hedge value.

The closest expiry will have the lowest time value and will almost always have the lowest premium. So, weekly options are usually best to target, though not all stocks have weeklies.

In India, stocks don't have weekly options. So, whichever option is expiring soon (usually the current month options) is your best bet for executing this.

With this method, you'll receive the dividend on the ex-dividend date (you'll officially receive it on the payable date).

A drop in the price of the stock will increase the “moneyness” of the put option.

If it lands ITM, it will obligate you to sell the stock at the put option’s strike price. This way, you pocket the dividend from holding the stock. If the stock price declines, you have a hedge in place to protect you from the price drop.

2. Using call options.

Instead of buying ITM puts, you sell ITM calls. You sell the near-expiry calls when the call options & stock price are both peaking. After the calls decline on the ex-dividend date, you close the position by buying back the calls.

For the arbitrage play to work, there are some conditions.

D > C - (S - P)

If the dividend payout (D) more than the cost of the option (C) less the extrinsic value of the option (strike price - stock price), we have a zero-risk dividend arbitrage strategy opportunity.

Ex: Consider a company pays 13 rupees dividend per share.

Let's say an ITM put option costs 18 rupees. The strike is currently 10 rupees higher than the stock price.

Here: D=13, C=18, S-P = 10.

13 > 8 (18-10)

This situation works.

What's the risk in this strategy?

For some reason, if the stock price rallies instead of falling, either due to broader market or some other announcement, this strategy will fail.

The successful execution of this strategy also depends on volatility of the stock. The price of an option is partially dependent on its implied volatility (IV). Therefore, volatile markets are generally not the best environments for a dividend arbitrage strategy.

If the combination of the implied volatility and time premium is too high relative to the dividend, then the trade isn’t eligible to be termed “dividend arbitrage”.

So, it's best to choose low volatility stocks (like ITC) instead of high volatility stocks.

- It's better to buy and sell 5 or more days around the ex-date. This dampens the knee jerk one day action and allows for less thoughtful investors to bid prices up just before the ex-date, and allows their market to recover somewhat if the stock takes a one day hit.

- Look for stocks with relatively high short sales ratios, at least 30% or greater. These stocks have inherent upward pricing pressure.

- Only do dividend arbitrage with stocks having betas of less than 0.7. Don't use stocks with market betas and avoid stocks with high beta.

Note: True dividend arbitrage opportunities are going to be relatively rare. These are competitive markets and other traders are also looking for free lunch opportunities where risk is negligible, reward is significant.

Effective arbitrage opportunities in the public markets are typically spotted by machines specifically programmed to find them. They normally last for very short periods because big funds take advantage of them quickly.

When they do exist the returns on them are small, so, large amounts of capital is needed to benefit from their occurrence.

So, while this is a good strategy to have as part of your trading arsenal, if you're able to spot an opportunity, you must have the capital to jump on it.