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Trading Ex-Dividend Strategy

Trading Ex-Dividend Strategy

Summary - For most investors, dividend investing is a straightforward, conservative investment strategy. There are many benefits to investing in dividend-paying companies. Dividends can provide a hedge against the inherent risk in the market because they offer at least a partial return on investment. And while there are no guarantees in the market, once a company starts to issue a dividend, they typically work very hard to continue to offer one – and increase it if possible. In fact, the elite group of companies known as "dividend aristocrats" have achieved this status by increasing their dividend payouts for more than 25 consecutive years. The average compounded annual growth rate for dividends of S&P 500 companies is 3.2%.

In order to be eligible to receive a dividend, an investor must be a shareholder of record before a company’s ex-dividend date. This is the date when the stock begins to trade at a price that reflects the discounting of the dividend. Some investors choose to pursue an aggressive trading strategy that allows them to profit from this period. The strategy, commonly referred to as dividend capture, allows active traders to close a trade as late as the day before the ex-dividend date and then sell the stock on or shortly after the ex-dividend date in order to collect both the dividend and a capital gain from the sale of the stock.

In theory, a dividend capture strategy should never be profitable because the price of a stock will normally decline in correlation to the amount of the dividend. However, dividend capture seeks to take advantage of the fact that dividend-paying stocks do not always trade precisely according to a formula or by conventional logic.

Executing an investing ex-dividend strategy carries both above-average risks and possible tax consequences. In addition, because the margins can be very small, individual investors will usually have to be willing to trade a fairly high dollar amount to make these trades profitable.

Introduction

Experienced and novice investors alike know the value of dividend stocks. These companies, sometimes referred to as “dividend aristocrats” because of their long history of making consistent dividend payments, make rewarding their shareholders a priority by paying out a quarterly or annual cash dividend. Dividends are known as conservative, low-risk investments because many of the companies that pay dividends are established, blue-chip companies. These stocks typically have a beta that is pretty close to 1, meaning their stock is no more or less volatile than the broader market.

However ever since interest rates reached all-time lows when the Federal Reserve instituted its zero-interest policy during the financial crisis of 2007-2008, even more, growth-oriented investors are seeing the benefit of owning dividend stocks. After all, if a company is paying a dividend of 3-4% when interest rates are still hovering at just over 2%, that dividend becomes much more attractive.

Dividends are paid out on a regular basis and require an investor to be a shareholder on what is called the ex-dividend date. This is the date on which the stock is trading at a discount because the market is already reflecting that it has paid its dividend. Institutional investors who have lots of capital and access to high-speed trading systems take advantage of this period of time by instituting dividend capture trading to not only capture the dividend but to generate a profitable trade without being required to hold onto the stock for a long period of time. However, since electronic trading has become available to individual investors, this trading strategy, known as dividend capture, has become common for individual traders, usually day traders.

In this article, we’ll go into detail about the mechanics of trading ex-dividend. In doing so, we’ll define the process companies must go through to issue a dividend and why trading ex-dividend is not a profitable option for every investor.

What does it mean to trade ex-dividend?

Trading ex-dividend means to enter a trade prior to a stock’s ex-dividend date and closing the trade shortly after the date. Ex-dividend means “without the dividend”. When a company pays a dividend, the value of that dividend is reflected in its stock price. However, once a dividend is declared the market pays close attention to what is called the ex-dividend date. Typically, the ex-dividend date is set for two business days before the record date. On the ex-dividend date, the price of the stock will be discounted to reflect the dividend that the company will be paying to its shareholders. So during this ex-dividend period, the stock is said to be trading without the dividend added to its stock price.

Here is a simple example that illustrates how the ex-dividend date affects a stock price:

The ABC Company declares an annual dividend of 3%. Their stock price is currently trading at $150 per share. On the ex-dividend date, at the opening of trading, the market will be marked down by 3% ($4.50). This means that any investor buying a stock at that moment will pay $145.50. They will not be eligible to receive the upcoming dividend unless they were already a shareholder. Dividends, however, are not pro-rated. So whether an investor became a shareholder one day or one year before the ex-dividend date, they are entitled to the entire dividend. And that’s where the concept of trading ex-dividend comes in. Frequently referred to as dividend capture, trading ex-dividend is a strategy that seeks to capitalize on the assumption that irregularities exist in the market.

Before going into detail about what an ex-dividend trade looks like, let’s define some key dates that establish a timeline that a company must follow before issuing a dividend.

What is the process for a company to issue a dividend?

There are four key dates that are part of the dividend issuing process.

Record Date– this is the date set by a company’s board of directors once they decide to issue a dividend. An investor must be on the company’s record as a shareholder on this date to receive the dividend. Currently, the record date is set for one day after the ex-dividend date.

Ex-Dividend Date– once the record date is set the stock market will automatically set the ex-dividend date. As mentioned above, this date will typically be two days before the record date. The ex-dividend date is a firm date. In order to qualify for the dividend, a shareholder must be a shareholder of record before the ex-dividend date. Although many stock transactions seem to be handled almost instantaneously, most trades take two days to “settle”. This settlement time can cause a delay between an investor being listed as “on the record” to receive a dividend.

Declaration Date– this is simply the day the company announces to the public that they are issuing a dividend. In this announcement, the company will list how much the dividend will be, the ex-dividend date and the payment date. Chronologically, this would occur after the record and ex-dividend date have been set.

Payment Date– this is the date when the dividend payments are distributed to shareholders. This is typically at least two weeks after the record date.

Let’s look at an example of how all these dates work together.

On October 9, 2018, Procter & Gamble (NYSE: PG) declared a dividend of $0.71/share (the declaration date) to be paid on November 15 (the payment date). The ex-dividend date was set for October 18, 2018, making the record date October 19, 2018.

How do investors learn about ex-dividend dates?

Companies are proud of their ability to issue a dividend and will typically have this information available to shareholders and prospective investors on their website, probably in an area called "Investor Relations" or something similar. In addition, many financial websites will have ex-dividend calendars that will provide a list of all announced ex-dividend dates. This is an easy way for investors to see not only the ex-dividend date of a company they may be interested in buying but a comparison of dividend amounts for similar companies. Once the ex-dividend date arrives you'll see an X next to the stock symbol to indicate that it is trading ex-dividend.

How to execute a trade ex-dividend strategy?

The idea behind trading ex-dividend (or dividend capture strategy) is simple. Because there is no pro-rating of dividends, an investor can purchase shares of a company’s stock the day before the ex-dividend date and sell the shares on the ex-dividend date or whenever they want and still receive the entire dividend. But the idea behind trading ex-dividend is to capture the dividend PLUS a capital gain. Here's a "perfect" example of a dividend capture strategy at work in a portfolio worth $500,000. For this example, we'll use a completely arbitrary amount of $50,000 to simplify the math. In the real world, investors would not be likely to allocate 10% of their portfolio in a single position.

An investor owns $50,000 worth of a blue-chip stock that has a dividend yield of 3% that is paid quarterly. That means every quarter, the investor will receive $375 (3% of 50,000 = 1,500/4 = $375). On the ex-dividend day, the stock starts out at a discounted price (reflecting the dividend) but quickly moves up to a price that was higher than it was on the ex-dividend date. The investor sells his position and captures the dividend (hence the name dividend capture) AND a capital gain.

This, however, is a perfect example. In the normal course of trading, stocks do not always behave the way investors would like or expect. Let’s take a look at one such scenario:

Let’s say a stock was selling for $50 and announced a $0.50 dividend. In a perfect scenario, the stock price would drop $0.50 on the ex-dividend date. However, the $0.50 dividend was below the company’s previous dividend. This caused investors to get concerned that the declining dividend was a signal that the stock price was ready to decline.  Although it’s unlikely that many investors would sell before the ex-dividend date, there could be a lot of investors who sell on the ex-dividend date. A trader who is trying to execute a dividend capture strategy on the ex-dividend date could easily find themselves trading the stock at a loss.

Here’s another example of where a dividend capture strategy can work. There are times when a stock, for any number of reasons, may not be marked down to the expected amount dictated on the declaration date. In our example above let’s say the stock that was expected to drop by $0.50 only dropped by $0.25. An investor could go through the following process:

  1. Buy the stock prior to the ex-dividend date for $50
  2. Sell it on the ex-dividend date for $49.75
  3. They collect the dividend of $0.50 on the payment date
  4. They realize a total return of $0.25/share. They lost $0.25 on the stock but gained $0.50 on the dividend distribution.

In both of these examples, the watchword is patience. To execute a profitable ex-dividend trade, investors should be sure to choose a stock in which the price is likely to quickly return to the price it was at prior to the ex-dividend date. This may mean waiting a day or several days after the ex-dividend date.

Other risks to trading ex-dividend

In addition to market anomalies, there are other risks that can make it difficult for dividend capture to be a profitable strategy. First, trading ex-dividend usually requires a significant capital investment. The spread between the expected price and the actual ex-dividend price may not be very significant. For these trades to be profitable, would require a larger spread (which is out of a trader’s control) or a more significant investment.

Another risk is taxes. Qualified dividends will typically receive preferential tax treatment. But that usually means the stock would have had to be owned for more than 61 days. In many cases, investors who are trading ex-dividend are only holding the stock for at most a few days before the ex-dividend date.

Yet another risk is trading costs. In many cases, it will cost an investor more than $0.25/share to execute a trade. These costs, which are typically paid out on both ends of the trade, easily turn a profitable trade into a losing trade.

The bottom line on trading ex-dividend

Although dividend investors are typical of the buy-and-hold variety, there are many savvy investors who use the period of time after a dividend is announced to trade a dividend stock.

In its simplest form, trading ex-dividend works like this. You will purchase stock after its ex-dividend date and sell your stock on the ex-dividend date or shortly thereafter collecting both the dividend from the stock as well as a capital gain from the sale of the stock. When this happens, an investor will need to know the ex-dividend date for the stock they wish to purchase. Only investors who own the stock before the ex-dividend date will be considered a shareholder of record and receive the scheduled dividend. The ex-dividend date is a firm date and once the date arrives, any new investors that buy the stock will not receive the upcoming dividend.

Trading ex-dividend is the underlying concept behind an active trading strategy known as dividend capture where high-frequency traders, such as day traders, try to hold a stock only long enough to collect (or capture) the dividend and immediately sell the stock. 

In a perfect market, a stock’s share price will drop in the exact amount of the dividend on the ex-dividend date. If it did so, a trader seeking to profit from a dividend capture trade would be selling their shares at a loss. Therefore, although simple in theory, a dividend capture trade is a risky strategy that requires a belief that the markets will not behave with perfect logic and that the price of the stock will fall less than the price of the dividend, allowing room for profit.

Investors that are wondering when a company is issuing a dividend can usually find this information on a company's website or other financial sites. Dividend-issuing companies are usually very proud of this fact and make the information of an announced dividend readily available to investors.

 

 

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