By Steve Papale
I don’t need to speak on the dangers of drinking and driving. But I have to say, I saw a video the other day that I could hardly believe. Taken from a police car in a community not too far from me in Illinois, a car was driving along on a fairly busy street with a, get this, a tree stuck to her hood. It was not a branch or a twig laying on top of the hood but a tree in the upright position somehow lodged into the grille all the while the driver, a 54 year old woman, drove the car. Needless to say, she was pulled over and failed her breathalyzer test. Some of this stuff just gets weirder and weirder.
Last week we talked a little about the concept of parity. And how parity is closely tied to synthetics, which is the principle that options and stock can be combined to create a like product. For example, I can buy a call and sell stock in proportion to create a synthetic long put. It will behave and have the same risk/reward characteristics as a outright long put.
In trading, if there is a mispricing between two like products, an opportunity exists to buy the cheaper and sell the expensive called an arbitrage. Outside of a pure scalp, which is buying and then quickly selling the same product, it is the most risk free way of making money. In the old days where markets were a bit more inefficient, arbitrage opportunities were fairly common but today with mature and efficient markets they are rare. But they do frequently appear to show up but in reality they are not real. Let me explain.
Every quarter a few days ahead of ex dividend day, the options market begin to incorporate the dividend into the pricing of the options. Only shares of stock purchased before ex dividend date will shareholders be able to receive the dividend. On ex dividend date the stock typically discounts the dividend payment amount from the price of the stock. Obviously there are other factors affecting the price of a stock but everything else equal, the stock will drop in price by the amount of the dividend on that day even though the actual payment date is later.
The other day WMT was 2 days before it’s ex dividend date. The quarterly dividend was $0.50 with the stock trading around $67. Looking at the synthetics in the front month options however, the calls and puts were pricing the stock around$66.75. It appeared that there was an arb sitting there. It looked like someone could buy 1 Mar 65 call and sell 1 Mar 65 put and based on the prices could create +100 shares of WMT for $66.75. By then selling 100 shares of WMT in the market for $67 it looked like there was a risk free arb for $0.25. However, as they say “there is no free lunch”. This strategy means being short 100 shares of WMT which means the seller is on the hook for the dividend, in this case $0.50. Taking in account the dividend payment, what looked like a $0.25 winner turns into a $0.25 loser. Bottom line: rarely is there free money sitting around. If you spot something that looks like an easy arb double and triple check the ex dividend date, the option prices and that your math is correct. And if it stays around for more than 5 seconds, don’t trade it. It will end up costing you money.