I’m generally loathe to discuss complex option strategies, but given that bond yields have vaporized and investors are looking for any chance to generate income, I think discussing the dividend arbitrage strategy has merit.

Dividend arbitrage is designed to create a risk-free profit by hedging a dividend-paying stock from downside risk while waiting for those dividends to be issued. If you do it right, you make the dividend payment less the premium paid for the option hedge.

First, let’s review dividend payment dates and price movements. The ex-dividend day is the last trading day when you get to reap a dividend as an official owner of the stock. The stock will decline by the same amount as the dividend per share on that day. So that’s why just buying the stock for a dividend doesn’t work — you lose in stock price what you gain in dividend payment. Also, the stock might takes days or weeks to actually pay out that dividend, so you still are exposed to a loss if you hold the stock during that period. What to do?

You want to buy an in-the-money put that has extrinsic value lower than the dividend you get paid to hedge against that downside risk. Just make sure the cost to hedge is less than the dividend paid.

Now, it’s tough to find these opportunities because the dividends that get paid have to be announced a few weeks ahead of the ex-dividend date, and that gets priced into the put option, which increases their extrinsic value. So here’s what you do:

• Buy a stock just before ex-dividend day.
• Buy an equivalent number of in-the-money puts with extrinsic value lower than the dividends receivable.
• Hold this position until the dividends are paid.
• Exercise the puts, which will cause the stock to be sold at the put strike price at no loss (other than what you paid).
• Your profit is the difference between dividends received and extrinsic value of put options bought.

You are wondering what the heck happens if the stock, in fact, drops by the time the dividend gets paid. You’re protected. That’s why you bought the puts.

OK, so what if the stock takes off instead? Hey, as long as the price goes above the strike price of the puts, that’s gravy profit for you.

I’d like to provide a hardcore example here, but it’s tough to hunt down a dividend arbitrage opportunity. So instead, I’ll use a hypothetical.

Let’s pretend we’re playing with General Electric (NYSE:GE). Say GE was trading at $25, and its June 28 Put was trading at $2.25 and it pays a 50-cent dividend.

• Buy 100 shares of GE at $25 just before ex-dividend day.
• Buy a June 28 Put for $2.25.
• So far, your net investment is $2,725.
• Dividend of $50 is paid.
• Exercise your put, selling GE at $28 for $2,800.
• You end with a profit of $125.

Remember, this is a hypothetical. Your mileage may vary.

As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at pdlcapital66@gmail.com and follow his tweets @ichabodscranium.