Dividend Arbitrage

This was something I wanted to share for a while. This term is not coined by myself but found some one using it and I liked it a lot. More over it truly can be called as arbitrage with asterisk and not purely arbitrage :)

I don't have to write what arbitrage is in financial market. Instead of writing all complicated financial jargon we can call arbitrage as 'making profit with zero risks'.

Since this strategy involves reasonable downside protection upto certain extent I call it arbitrage with asterisk. The real arbitrages (no loss what so ever) are really really short lived and usual investors cannot identify and make profits.

This strategy involves buying covered call with deep in the money calls for healthy dividend paying GOOD stocks. You short deep in money options where time value gives you certain percentage of protection below the strike price you are selling. I prefer at least 4-5 % protection below strike price. This is additional gains for you. More the better.

Here I am showing an example of Verizon (VZ ). VZ pays a healthy dividend of roughly 5 % per annum and with good fundamentals, I am comfortable having a position for extended duration without loosing sleep at night. If I hold VZ for extended duration I can get 5 % returns with no question asked. But we want more. This is where you go short on call options.

Please look @ images below that shows the closing price of VZ along with call option prices for various strikes for Jan 13. It shows percentage returns and downside protections for those strikes. Strikes 30,35 are in the money, 37 ...well can be called at the money and rest out of money.

The details of table are plotted in figures below highlighting time value and percentage protection with respect to strike price.

As you go deep in money the protection offered increases along with reduced initial investment (effective buying price) but at the cost of lost time value. More over as the time value decreases with deep in money calls the possibility of you getting called increases as buyers of those calls have motivation to exercise options if the dividend received is more than time value paid.

Time value is the money you will earn along with additional dividend. The most time value you earn is at the money (strike 37). As you go away from 37 in either direction you loose time value.

As you go out of money and if options are exercised that means the stock price is greater than strike the percentage return increases due to growth in the stock price but for VZ I doubt it will go to 40 till next year.








Based on current market conditions it makes sense to sell at the money calls and get total returns 10+ %. This returns can be further extended couple of percentage points by keeping a keen watch on market. As the stock prices decreases with it usual up and down market movements, the options sold will be in profit. When the price drops a lot, and if you are sure VZ will bounce back to its current level, you can book the profit on options sold and wait for bounce back. Once the price bounces back, you can again sell the options. Also if the stock prices don't change and time goes by, the options sold will still be in profit ( time value loss), you can close the options and sell new options with higher time value.

This strategy can easily deliver 14 - 15 % return on annual basis if done properly along with reasonable downside protection.

This will not give returns like 1200% you can get with the speculative options trading. But that involves huge risk. May be some time later will write on it too. As that is also one of my trading strategies.

I like to put my money where my mouth is. :) This article is based on my own personal trading strategy with VZ , TOT , AGNC etc.