Security Futures Tied to Dividend Whipping Post

The Critical Dividend Yield

If the long single-stock future position on a dividend-paying stock was profitable, the ordinary income of the dividend was converted into the appropriate capital gain. If the long position lost money, the accrued dividend got buried in the capital loss, a distinct advantage to those infuriating situations when you have to pay dividend taxes on a money-losing stock or mutual fund. In either case, being long the single-stock future of a dividend-paying stock was preferable from the dividend taxation point of view to owning the stock.

At zero taxation, a profitable long position on a dividend-paying stock will always have an advantage over a profitable long single-stock future. The stock's dividend will be tax-free and the cost basis of the stock will be adjusted higher for capital gains purposes, while the single-stock future's capital gain will be taxed at the appropriate capital gains rate, and no adjustment in cost basis is contemplated at present. Of course, capital gains on single-stock futures can be offset by losses elsewhere.

For short positions, the outcome is different, even in ways different than the interest rate differentials described in a previous article. The seller of a single-stock future on a high-dividend stock pays on the stock over time in the form of the same accrual noted above (dividend minus interest rate).

A short single-stock future on a dividend-paying stock whose price declines by less than this amount (dividend minus interest rate), adjusted for ex-dividend trading, over the life of the trade will lose money and throw off a short-term capital loss that can be used to offset gains elsewhere. This is the critical dividend yield. Should the stock fall further, a short-term capital gains tax liability can be created.

Hedging

If this short single-stock future is combined with a long position in the stock, a classic hedge that is margined at only 5% of the current market value if the single-stock future is held in a securities account instead of a futures account, a tax arbitrage appears.