Dividend Arbitrage
Call Option Dividend Arbitrage
A type of options activity that you may see often is ‘dividend arbitrage’.
This is an advanced trade that has no directional bias to it that seeks to take advantage of the market mechanics behind dividend payouts.
This will be as simple of an overview as I can come up with, given the general complexity of this activity.
When it takes place
The trade itself will take place on an equity that trades ex-dividend the following session.
For example:
If $AAPL's ex-dividend date is Wednesday, January 10 then the dividend trade would take place on Tuesday, January 9th.
If $AAPL's ex-dividend date is Monday, January 10 then the dividend trade would take place on the previous Friday, January 7th.
What it looks like
A trader will open a deep ITM call debit spread on an equity that trades ex-dividend the following session. This call debit spread can be opened as a multileg trade or be legged into via two single leg trades.
Here's a look at a bunch of $AVGO call transactions from June 18th (market closed June 19th for holiday, ex-dividend date June 20th):
In this instance the call spreads are being legged into, given that this entire page of activity consists of single leg activity.
Note that the strike prices are deep in the money and that the total premiums transacted can be in the millions and tens of millions.
It bears repeating: this activity has no directional bias.
Given the volume and premiums, however, dividend call activity can set off different types of volume/activity scanners that traders may have. Case and point: $AVGO saw 3.5x more options volume than the 30 day average.
Here's another look, this time on $RTX back from 2024. In this case the entire page consists of multileg activity, indicating that the spreads were not legged into but rather opened outright:
Again: note that the strike prices are in the money and that the total premiums (and volumes) are quite high.
What actually happens
A trader opens a long call spread on a stock that trades ex-div the following session (2 traders will often link up to act as the counterparty to the other's action. See the #hypothetical example).
Once the trader has opened the spread the long call is exercised, which results in a position of being long stock while having a short call position.
Options assignment is completely random, so there is no guarantee that an exercise will result in the respective number of shares.
The traders using this strategy may profit from being short the in-exercise calls if the holders of the long call positions do not exercise.
On the ex-dividend date, if the traders are assigned on less than their full short call position, they may profit as the calls lose value when the share price falls, while their loss in the long stock position is exactly offset by the receipt of the dividend.
Here is a look at the updated open interest values on some of the $AVGO contracts that were exercised:
The open interest has dropped off significantly, given all of the arbitragers competing with each other for the available open interest.
Certain options exchanges actually incentivize this type of activity by offering it to their customers for reduced fees, which is effectively the only way in which this trade can be profitable.
Simple Hypothetical Example
Market Maker Jack buys a call spread from Market Maker Jill, who in turn buys a call spread from Market Maker Jack on the day prior to ex-div.
Jack and Jill both exercise their long calls.
Now only short the call sales from the call spreads (and long stock from the exercised calls), the traders hope that the OCC assignment process results in them receiving assignments on less than their entire positions.
If this happens, they will remain short some calls and long XYZ shares, on which they will receive the dividend.
Remaining options exposure can be hedged by buying inexpensive puts to leg into the “conversion” side of a reversal/conversion trade.
The large volume of the trade served to crowd out the original natural short call open interest and effectively transferred most of the profitable short call, long stock position to the two traders.
Advanced Hypothetical Example
Here is a simplified example that takes place on the sessions PRIOR to the ex-dividend date:
• Stock XYZ is trading at $50 and will pay a dividend of $0.10 per share.
• In this simplified example let's assume that the market makers have agreed to use the dividend trade strategy in the $40 calls for stock XYZ.
• Open interest in the $40 calls (at the beginning of the trading day) is 10,000.
Transactions:
• Market Makers A and B trade the $40 calls back and forth with one another. At the end of the day they end up with the following positions in the $40 calls:
Market Maker A | Market Maker B | ||
---|---|---|---|
Long positions | Short Positions | Long positions | Short Positions |
500,000 options contracts | 500,000 options contracts | 500,000 options contracts | 500,000 options contracts |
Exercise Process
• In this example say 90% of market participants in the original open interest pool exercise their call options. Because open interest was originally 10,000 contracts this means that 9,000 contracts remain unexercised.
• Market Makers A and B exercise all of their long options positions, meaning they are now long the stock.
Market Maker A | Market Maker B | ||
---|---|---|---|
Long positions | Short positions | Long positions | Short positions |
500,000 options contracts | 500,000 options contracts | 500,000 options contracts | 500,000 options contracts |
Exercise all long options positions | Exercise all long options positions | ||
50,000,000 shares | 50,000,000 shares |
Assignment Process
• 1,009,000 call options have been exercised out of a total of 1,010,000 that were outstanding.
• OCC now randomly selects investors who hold short positions to close the stock for each call option that has been exercised.
• An investor who is short the position has a 99.9% chance of being assigned to deliver the stock (1,009,000 call options exercised/1,010,000 open short positions).
• That same investor also has a 0.1% chance of remaining short (1,000 unexercised call options/1,010,000 open short positions).
Market Maker A | Market Maker B | |||
---|---|---|---|---|
Long positions | Short positions | Long positions | Short positions | |
50,000,000 shares | 50,000,000 shares | |||
499,500 options contracts remain short | 499,500 options contracts remain short | |||
In this example, say 499,500 short positions | In this example, say 499,500 short positions | |||
Step 1: | (99.9%) are assigned | (99.9%) are assigned | ||
Step 2: | 50,000,000 shares | 49,950,000 shares must be delivered | 50,000,000 shares | 49,950,000 shares must be delivered |
Fully hedged position: | 50,000 shares | 500 options contracts remain short | 40,000 shares | 500 options contracts remain short |
At the end of the day…
• Market Maker A has exercised 500,000 call options, but must turn around and deliver against 99.9% of his 500,000 short call positions (499,500 call options). Market Maker A retains a balance of 500 short call options. He holds stock for 500 of the long call options he exercised and ends up with 50,000 shares of Stock XYZ (1 option contract = 100 underlying shares). He collects a dividend of $0.10 on each of these shares, or $5,000 total.
• Market Maker B has exercised 500,000 call options, but must turn around and deliver against 99.9% of his 500,000 short call positions (499,500 call options). Market Maker B retains a balance of 500 short call options. He holds stock for 500 of the long call options he exercised and ends up with 40,000 shares of Stock XYZ. He collects a dividend of $0.10 on each of these shares, or $4,000 total.
• Both market makers have collected the dividend payments associated with those shares, and both remain fully hedged with short deep-in-the-money calls. This means they can trade out of their hedged position but will wait until expiration if it is near after they collect the dividend.
TLDR
Dividend arbitrage is a complex strategy that cannot be replicated by retail traders.
The best a retail trader can do is understand them for what they are and to be able to identify them.