In part I of this arbitrage series we defined arbitrage as the simultaneous purchase and sale of an asset to profit from a difference in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms. Arbitrage exists because of market inefficiencies. We viewed these market inefficiencies from the perspective of call and put buyers when in-the-money strikes traded less than parity. In this article, we will add the element of dividends into the equations and explore when arbitrage opportunities may arise.

The assumptions in this analysis is that strikes are in-the-money, the time value of the option is less than the future dividend distribution and the dividend ex-date is prior to contract expiration.

dividends and covered call writing

Dividend Ex-Dates in our Premium Reports

 

Early exercise and arbitrage opportunities for call buyers

Let’s set up a basic example with the following hypotheticals:

  • Stock BCI trades at $40.00
  • The $30.00 call has a premium of $10.25 (time of $0.25)
  • The dividend distribution will be $0.50

Initially, early exercise appears to make sense because we are benefitting by the $0.50 dividend distribution which is greater than the $0.25 of time value that can be captured if the option is sold. In this scenario the arbitrage opportunity involves exercising the call (losing the $0.25 of time value), buying the stock and seemingly benefitting by $25.00 per contract. In reality, it is a breakeven because share value will decline by the dividend amount.

The reason this does not represent the best arbitrage opportunity is because the option can be sold (capturing $0.25 of time value profit), the stock purchased prior to the ex-date and then the dividend distribution can also be captured for a seemingly net gain of $0.75. In reality, the gain is $0.25 because share value will decline by the dividend amount. Please note that in both instances, share value will decline by the dividend amount. Capturing the time value of the option premium is the advantage of this latter approach. An example of a price decline on the ex-date is reflected in the screenshot below:

 

dividends and covered call writing

Costco Price Decline on the Ex-Date

February 6th was the ex-date for Costco Wholesale Corp. (NASDAQ: COST). The blue arrow highlights the price decline resulting from the upcoming dividend distribution.

 

Why are we concerned about early exercise as it relates to ex-dates and covered call writing?

Many retail investors are not aware that both time value and dividends can be realized and therefore submit exercise notices when the dividend is greater than the time value component of the option. To protect ourselves from potential tax issues in non-sheltered accounts we must factor in this possibility even though it is remote and not the best choice for the call holder.

 

There may be arbitrage opportunities for put buyers

First, let’s set up a basic example with the following hypotheticals:

  • Stock BCI trades at $30.00
  • The $40.00 in-the-money put has a premium of $10.25 (time of $0.25)
  • The dividend distribution will be $0.50

The put is purchased at $10.25 and the stock is purchased at $30.00. On the ex-date, the put is exercised, selling the stock for $40.00. Since the stock was owned on the ex-date, the dividend will be captured on the pay date. The arbitrage results in a credit of $0.25:

[($40.00 – $30.00) + $0.50] – $10.25 = +$0.25

 

Discussion

Arbitrage opportunities may be available to put buyers when the time value component of the option premium is less than the dividend about to be distributed. When writing covered calls and ex-dates exist prior to contract expiration, there is no advantage to early exercise for the call buyer but retail investors may make the choice to exercise early to capture the dividend despite the fact that this is not the best choice.

 

Upcoming speaking event

Orlando Money Show

February 8th –  11th, 2018

Click for information

I will also be part of the event opening All Stars of Options Presentations.

 

Market tone

 This week’s economic news of importance:

  • NAHB home builders index 74 (70 previous)
  • Housing starts for November 1297 (above expectations)
  • Building permits November 1298 (1316 previous)
  • Existing home sales above expectations
  • Weekly jobless claims 245,000 (above expectations)
  • GDP revision to 3.2% (3.3% expected)
  • Leading indicators for November 0.4% (previous 1.2%)

 

THE WEEK AHEAD

Mon Dec 25th

  • None scheduled

Tue Dec 26th

  • Case-Shiller home prices for Oct

Wed Dec 27th

  • Consumer confidence index for Dec.
  • Pending home sales Nov.

Thu Dec 28th

  • Weekly jobless claims
  • Chicago PMI for Dec.

Fri Dec 29th

  • None scheduled

 

For the week, the S&P 500 rose by 0.28% for a year-to-date return of 19.85%

Summary

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of August 31, 2017

BCI: My portfolio makeup moves to a bullish bias with the passage of the tax bill which should be a positive for the stock market, selling 2 out-of-the-money strikes for every 1 in-the-money strike.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a slightly bullish outlook. In the past six months, the S&P 500 was up 10% while the VIX (9.90) moved down by 5%.

Happy holidays to one and all,

Alan and the BCI team