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Anatomy Of A Dividend Arbitrage - Buy CVI Monday, Sell The March $50 Covered Calls

|Includes:CVR Energy, Inc. (CVI)

Anatomy Of A Dividend Arbitrage Play - Make Big Returns With Low Risk On CVI Monday !

Today I want to discuss a real life Arbitrage play that is in its final couple of days of potential window for trading. This is a real investment opportunity to lock in unusually large gains at ultra low risk.

Arbitrage is defined by wikipedia as: "... the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. Generally it is accepted to refer to the simultaneous buying of one position and selling of another position in the same or closely linked instruments such that you lock in a favorable price differential and thus insure a profit. Typically Arbitrage trades are for fractions of a penny or a few pennies per share and the trade is done on huge numbers of shares so as to multiply the miniscule price advantage into a sizeable profit.

Because of the tiny price differentials in most arbitrage (fractions of a cent) such trading is mostly limited to the ultra large professional trader who can quickly move to buy and sell 100,000s or even millions of shares, but there are some rare exceptions that make sense for the individual looking for an extremely low risk opportunity to lock in a quick return when they find a pair of related trades with a favorable price spread locked in between them.

Lets look at today's real world example that exists right now in CVR Energy, Inc. (NYSE:CVI):

Current price: $54.70

Average daily volume: 354,000 shares

P/E: 11.87

Market Cap: $ 4.75 billion

Dividend: $3/yr paid quarterly

There are the basics. The stock has been a strong performer this past year and continues to be so, largely thanks to Boone Pickens taking an interest and active roll in the company in a manner that is making efficient use of company resources in a way to maximize shareholder value. It is in fact this very management practice that sets up the conditions of today's arbitrage play...

CVI has declared a special dividend or $5.50 per share payable to holders of record 2/5/2013. They have also announced the intent to pay $3/share total in ordinary quarterly dividends for 2013.

The stock less the special dividend means that holders of record will have an effective cost of $54.70 - $5.50 = $49.20 by purchasing in time to be of record for the dividend on February 5th.

Now, the other side of the arbitrage, Selling covered calls for March2013 @ $50.00 share strike price. The current premium to the seller (YOU) on this is $5.30 per share. Deducting this cash premium received for the covered call reduces your basis cost per share down to $43.90 per share.

Thus, we have the following possible results of this set of trades:

1. The call option is exercised for $50/share sometime after the February 5th special dividend record date: This results in you receiving $50/share call price on your net basis $43.90/share stock for a profit of $6.10 / share on stock held somewhere between approximately 5 and 50 days (March 16 option expire date).

Thus your initial investment of the stock cost less the option premium received = 54.70 - 5.30 = $49.40 (remember, you'll be waiting until 15 February to receive your 5.50 cash special dividend). So, $6.10 profit on $49.40 = 12.3% (or 6.10 from 43.90 net invested after dividend = 13.9% ) returns in 5 to 50 day holding period. This is an astounding NON compounded annualized rate of return of 898% to 101.5% depending on the holding time in the 5 to 50 day between the dividend of record date and the option expire date on March 16. These returns are simply amazing and are with very minimal risk.

Possibility #2: The call option is exercised BEFORE the "of record date" and thus you do NOT receive the dividend of $5.50.

The math now changes to:

$54.70/share - 5.30 option premium = $ 49.40 / share basis value for you. Option called away within next few days (less than 5) at $50/share = net profit of $0.60/share = 1.2% profit in 5 days, or annualized rate of 87.6% , a still remarkable and attractive profit.

I have selected the March call option to sell rather than the February call for 2 reasons .. A) the premium is a little greater, and B) the time value portion of the premium makes it much less likely that the buyer of the call will exercise before the special dividend record date since they would be better off buying and using the February Call options to do that.

I have also selected the $50 strike price since it is likely the stock will drop $5.50 / share on the dividend pay date, thus making it very close to 50/50 probability the stock will be at the $50 strike price then.

Outcome #3 possibility:

Finally, the down side .. The stock drops below $50 by March 16 option expire date and you are left holding the stock.

In this case you have pocketed both the $5.50 special dividend and the $5.30 option premium and your net basis is $ 43.90 per share. So, unless the stock drops $10.80/share (19.75%) in the next 50 days, you continue to have a locked in profit.

Of course, any such a precipitous drop would likely offer you a chance to close out your positions in both the stock and call contracts at a profit before the such a full precipitous decline were to occur.

And at 43.90 basis per share, the $3 annual dividend yield represents a 6.8% dividend yield, so an attractive Hold for income yield strategy to stick with the stock in such a case.

Yes, some totally unforeseen factor might still take the profit out of this play. An asteroid might hit their refineries, Special dividends may be outlawed or taxed to death by congress in the next few days. But short of a major catastrophic event directed at CVI explicitly, this is about as low a risk opportunity as you will find and some of the highest return possible even from wildly speculative ventures.

That is the anatomy of a arbitrage play in a real world nutshell. One still available to trade Monday.

Every special dividend should be examined for such possible arbitrage opportunities for the individual player. Always keep in mind the fundamentals, technical chart trading points, and market liquidity for both the stock and the option.

Good luck and happy trading.

Disclosure: I am long CVI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I also am short covered calls on CVI for the March $50 strike

Disclosure: I am long CVI.

Additional disclosure: I am also short the March $50 covered calls for CVI

Stocks: CVI