Question

In the classroom we discussed that the value of American calls (as most traded options are in American type) will decline if the underlying stocks pay dividends, and therefore theoretically, the investors should sell an American call before dividends payment since the investors can buy it back with a lower price after dividends payment. However, in practice, it may not be a wise idea to sell your American call before the dividend payments and purchase back after the dividend payments. In other words, if you want to create a trading strategy to capture arbitrage profits by shorting a call immediately before the dividend payments and immediately closing out this short position by longing a call right after the dividend payments, there are some issues that may cause a failure of this strategy. Can you list those possible issues, there are 5 of them.

Answer 1

The possible issues which might cause the failure of the strategy are:

1. The investore selling the call might be losing the Dividend, for the investment which he had held on for so long

2. There might not be any seller of the call immediately after the dividend payments, this might make the short call a long one.

3. As per some companies policy, the dividend is paid to person holding the call immediately before the dividend payment, therefore anyone who is buying the call might not get the Dividend payment, thereby not attracting much buyers for the call

4. The market for buying the call for the longer run after the Dividend payment might fall, thereby causing a loss of the Arbitarge opportunity

5. The amount saved by the Arbitage profit might be lower than the Dividend payments. Thereby causing a loss to the investor