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.

One Covered call story

I am full time engineer part time trader who actively trades in US market with equities and options. Every now and then I try to come up with some or other strategy to minimize risk and maximize returns using either stocks or / and options. I have divided my portfolio in two parts. 75 % is based on low risk , high dividend stocks and rest is my high risk high return positions.

I would like to share an strategy that has been quite successful to me even in this down market. That is covered call strategy for a high dividend paying stock with reasonable volatility. I am going to share what I did with Total (TOT) and would like to know comments from readers, if I could have done something better.

Generally I follow this principle. The day before a high dividend paying stocks like TOT, ABT etc who have good average daily volume and volatility, I buy stocks and sell in the money calls for a current or next month. I always make sure I am getting a premium (in time value) is less than the dividend issued. So for example if TOT is issuing 1.42 $ dividend, and if I am selling a call for current month or next month which is 2-3 $ in the money I can easily get a time value premium of 0.5 to 0.8$. So if I am selling 4-5 options, I may get an easy premium of 200 to 300$. Since the option is in money and time value premium is less than total dividend, 9 out of 10 times I get called / assigned for the options sold. Since these transaction are settled mid night with my broker, Options House, I even don’t pay for any margin interest.

If I don’t get called then things get interesting. And this is the story of that. In July 2011 TOT was 59.XX and I bought covered call with Aug option Strike price of 55 and it cost me 54.XX $. I traded 4 spreads of these. Since the dividend was 1.42$, I was hoping I should get called in for the options and I would pocket easy 160 $ or so (before commission and assignment fees of 5$). Unfortunately I did not get called in and I was stuck with 400 TOT stocks. Good thing was that I received dividend of 1.4X$ per share resulting in dividend of 640$. On EX dividend date I rolled over August option to Jan 2012 options and received additional premium of 1.3$ per share pocketing 520$ more. (5.XX % effective annualized return without dividend)
As time was going by, and stock price was above 55, I was not so worried about anything. But then things started going south with S&P downgrading US followed by uncertainty associated with Greece and French banks. When it was hovering @ 52, I made another trade with covered call (assuming option will hedge me against further drop), I bought covered call with Jan 12 50 strike call options. I got this spread for 48.XX. (9 % return annualized basis).
But the down fall continued with TOT going 52 week low of 41.XX or so. Since I use options as hedge, I made another trade for one covered call spread with 42.5 strike which cost me 37.XX$. Luckily market rebound and I closed it @ 40 with profit of 250 $ in next two days. (10 % in two days , not bad).

Apart from that i bought 50 stocks couple of times and sold them at profit.

Following table shows my trades since July and my resulting price per share for current TOT positions with and without dividend.





Today TOT closed @ 50.94$ and my effective stock price of 50.83$ is well @ break even. TOT has huge potential of bouncing back to 60$ sometime soon. Most likely I will book good profit on them or will be selling options again.

Not to forget I received 1.42 X 400 + 0.8 X 600 = 1120$ in dividends so far and will be receiving more.

I am always in search of stocks with this kind of volatility with higher time premium with good dividend yield. With this strategy one can earn 10 to 12 % effective return combined with dividends.