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In my previous article Implementing Dividend Arbitrage: Verizon Wireless I discussed a strategy known as dividend arbitrage. This strategy consists of selling options on high yield stocks to both reduce risk and increase yield. Dividend arbitrage investors do not concern themselves with making gains in appreciation of stock price, but rather gains are achieved by collecting regular dividend payments.

Problems were inherent in implementing dividend arbitrage on Verizon Wireless (NYSE:VZ), as Verizon is a low-beta stock, which means that the premium on the options that were to be sold was minimal which increased the risk that the option would be exercised before the ex-dividend date. Additionally, the open interests for the deep in the money options was quite minimal, making the trade hard to execute and illiquid.

Conceptually, dividend arbitrage can work on any stock with an above average yield, but in practice the ideal stock for dividend arbitrage is one that is large cap (greater open interest for options), a high beta (grater options premiums), fundamentally sound, and consistent with dividend payments. Using these criterion I have been able to identify 3 stocks that would be ideal for dividend arbitrage and outline exactly how to trade them.

Covered Stock: A type of order that tells your brokers to buy a stock and simultaneously sell the desired option for a net price equaling the cost of the stock minus the price of the option sold.

Seadrill Limited (NYSE:SDRL)

About Seadrill: Seadrill Limited is a Bermuda-based company active in the oil and gas industry. The company operates a fleet of 60 units, comprising drillships, jack-up rigs, semi-submersible rigs and tender rigs for operations in shallow to ultra-deepwater areas.

Trade: Execute a covered stock of SDRL, buying the stock at market price (37.00) and selling Jan 13 Strike 29.8 Calls for a net price of (29.6). Jan 13 Strike 29.8 have a current open interest of 426.

Trade Objectives: Seadrill is an extremely high-yielding stock, as it is yielding 8.20%; therefore the dividend arbitrage trade on Seadrill is focused on minimizing risk rather than increasing buying power. By selling the strike 29.8 calls you have effectively reduced your buying price to 29.6 meaning capital will not be lost as long as SDRL trades above 29.6 at the date of option expiration. By selling the calls you have also collected ($0.20) in premium (this should cover trading costs) and about $3.00 in dividends if SDRL continues to pay at its current dividend. This trade allows you to lock in a yield of 10% while providing 19% downside protection.

Williams Partners L.P. (NYSE:WPZ)

About Williams Partners: Williams Partners a diversified master limited partnership formed by The Williams Companies, Inc. Williams is an integrated natural gas company focused on exploration and production, midstream gathering and processing, and interstate natural gas transportation primarily in the Rocky Mountains, Gulf Coast, Pacific Northwest, Eastern Seaboard and the Marcellus Shale in Pennsylvania.

Trade: Execute a covered stock of WPZ, buying the stock at market price (62.20) and selling Jan 13 Strike 40 Calls for a net price of (39.7). Strike 40 calls have a current open interest of 1000.

Trade Objectives: Williams Partners is currently yielding 4.9%; therefore the dividend arbitrage trade on Williams Partners is primarily to improve buying power. By selling the strike 40 calls, you have effectively reduced your buying price to $39.70 meaning capital will not be lost as long as WPZ trades above $39.70 at the date of option expiration. By selling the calls you have also collected ($0.25) in premium (this should cover trading costs) and about $2.92 in dividends if WPZ continues to pay at its current dividend. This trade allows you to lock in a yield of 7.2% while providing 33% downside protection.

Vale (NYSE:VALE)

About Vale: Vale SA is a Brazil-based metals and mining company. The company's product portfolio includes nickel, iron ore and iron ore pellets, manganese ore, ferroalloys, aluminum, fertilizers, copper and coal among others.

Trade: Execute a covered stock of WPZ, buying the stock at market price (24.50) and selling Jan 13 Strike 18 Calls for a net price of (17.64). Strike 18 calls have a current open interest of 205.

Trade Objectives: Vale is currently yielding 7.16%, therefore the dividend arbitrage trade on Vale is primarily to reduce risk. By selling the strike 18 calls you have effectively reduced your buying price to $17.64 meaning capital will not be lost as long as VALE trades above $17.64 at the date of option expiration. By selling the calls you have also collected ($0.36) in premium (this should cover trading costs) and about $1.73 in dividends if VALE continues to pay at its current dividend. This trade allows you to lock in a yield of 9.8% while providing 29% downside protection.

Source: More Dividend Arbitrage: Seadrill, Williams, Vale