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This is a level 3 question.
If deep in-the-money puts change almost dollar for dollar with fluctuations in the stock price, then why not buy front-month puts on stocks whose ex-dividend date is rapidly approaching, given that the value of the stock will certainly drop upon payment of its dividend?
It looks like you want to try your hand at dividend arbitrage. Let's look at some of the finer points of dividend arbitrage and see if we can grasp some of its subtleties. In one form of dividend arbitrage, a trader buys the stock as well as a put. To lock in trading profits, he'll wait for the stock to go ex-dividend, collect the dividend on the underlying stock and then exercise his put. The reason that the trader buys the stock as well as the put is to protect himself from an unexpected move. Sometimes a stock will rally on news of a dividend especially if the dividend is larger than expected. Therefore, for the trader there is no logic in buying just a deep in-the-money put expecting to make $0.25 to $1.00 or so on the dividend only to see the stock rally $4 or $5 in your face without the stock to offset the adverse move.
In theory, on a dividend-paying stock, all puts should have some time value equal to the price of the dividend. This is true even for deep in-the-money puts. Let's look at an example to clarify this concept.
Let's assume that ABC closes at 109 but will pay a $0.35 dividend tomorrow. Therefore a 115 put should trade for at least $6.35. This figure is arrived at by taking the put's strike price and subtracting the stock's closing price and then adding in the dividend amount (($115-$109)+$0.35) that the stock will drop the next day.
However, if the put's time value is less than the amount of the dividend, then an arbitrage can occur. Let's suppose that the 115 put option is selling at 6.15 while the stock is trading at 109 and about to go ex-dividend by $0.35.
The arbitrage dividend trader would buy the put at 6.15, buy the stock at 109, and then exercise the put at 115 when the stock goes ex-dividend.
Profit-and-loss-wise, we have the following payoff:
| Sold ABC short through option exercise |
$115 |
| Bought ABC stock originally to set up arbitrage |
$109 |
| Collects dividend from holding ABC |
$ 0.35 |
| Total proceeds received |
$ 6.35 |
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| Less proceeds paid out for put option |
$ 6.15 |
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| Profit from dividend arbitrage |
$ 0.20 |
As for arbitraging dividends with call options, there really is no effective way of doing so. This is because the stock will drop in price after the dividend, thereby forcing the call price to drop as well. Hope that helps answer your question on playing puts for the dividend move. Good luck with your trading.
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Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
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