Written by Justin Kuepper. Updated by TraderHQ Staff.
Many investors are drawn to dividend stocks because they provide a steady stream of income to supplement retirement income or simply provide some extra cash on the side. For public companies, paying out a portion of their net income as a dividend helps attract longer term investors and generally helps stabilize their stock price. Dividend stocks tend to be strong performers during economic downturns when cash is king.
For active traders, dividends present a unique opportunity to generate a profit from a source other than capital gains realized from buying and selling stocks. While investors may hold dividend stocks for the long-term, active traders look to buy these stocks just in time to receive a dividend payment and then turn around and sell them.
In this article, we’ll take a look at the dividend capture strategy and how active traders can use it to profit from dividends over the short-term.
The Dividend Capture Strategy 101
The dividend capture strategy focuses on quickly capturing dividends without holding onto a security for a long period of time. In simple terms, the strategy is executed by purchasing a dividend-paying stock prior to its ex-dividend date in order to secure the payout and then selling it the next day or after the stock bounces back. The idea is to generate a greater profit from the dividend yield than the loss incurred by buying and selling the stock.
For a detailed breakdown of how this strategy works and its limitations, see Investopedia’s guide to dividend capture.
There are four key dates that traders must know to execute the strategy:
- Declaration Date – The day that a company announces its next dividend payout date, which is usually done via a press release, conference call, or other medium.
- Ex-Dividend Date – The day that new buyers are NOT entitled to collect the next dividend payout, which results in a reduced share price reflecting that fact.
- Holder of Record Date – The day that a trader must be registered as a shareholder to collect the dividend payout, which is usually one business day after the ex-dividend date.
- Payment Date – The day that the dividend should be deposited into the trader’s brokerage account and the profit is realized.
Let’s take a look at a quick example:
Suppose that a trader finds a stock that’s trading at $10.00 per share with a $0.25 quarterly dividend and purchases the stock just before the ex-dividend date. On the ex-dividend date, the stock briefly falls to $9.75 per share to reflect the dividend payment, but quickly recovers to $10.00 per share as traders look to maintain the key resistance level. The trader holds onto the stock until the day after the holder-of-record date and then sells the stock for $10.00 per share after collecting the $0.25 per share dividend – yielding a 2.5% profit on the trade.
Does the Dividend Capture Strategy Work?
There is a lot of debate within the financial community about whether or not dividend capture strategies are effective. Since the strategy amounts to a form of arbitrage, academics believe that the market will act quickly to close the gap before traders can capitalize on the opportunity. The old adage “there is no free lunch” seems to confirm the belief that a “free” profit would ever be left in the market without everyone taking advantage of it. In reality, the truth lies somewhere in between.
The dividend capture strategy can be effective in certain scenarios. As the example above highlighted, the $10.00 price level was a key support level that the market has defended over time, which means that the temporary drop below was only likely to be temporary. These are the opportunities where the odds may favor the strategy’s success. In cases where there’s no technical support, traders may have a tougher time profiting from the strategy, while the movement could even trigger a bearish breakdown in some cases.
Finding Trade Candidates
The dividend capture strategy takes advantage of companies issuing dividends, which means that potential opportunities are simply dividend-paying stocks. In general, traders can identify these opportunities by tracking companies that have upcoming ex-dividend dates and then analyzing those opportunities on an individual basis to determine the strategy’s viability in the context of technical support and resistance levels.
There are many online resources for traders to identify stocks with upcoming ex-dividend dates and even analyze the profitability of the dividend capture strategy, including:
- Dividend.com Screener – Dividend.com’s Dividend Stock Screener provides advanced tools that let traders quickly screen for stocks with upcoming ex-dividend dates that meet a variety of different criteria, including things like dividend yields.
- Nasdaq Dividend Calendar – Nasdaq’s Dividend Calendar provides a calendar view of all stocks with upcoming ex-dividend dates. Traders can use the calendar as a starting point for their research of potential opportunities.
After identifying stocks with upcoming ex-dividend dates, the next step is determining the viability of a dividend capture strategy. The most important elements to watch for are key technical support and resistance levels, as well as any risks that may be involved with holding the stock for the requisite period before being entitled to the dividend. In addition to those concerns, traders should consider the commissions and tax consequences in order to ensure that the strategy is capable of generating a profit after all expenses are deducted.
Hedging with Covered Call Options
Covered call options provide a great way for traders to hedge dividend capture strategy positions in order to improve the odds of a successful trade. By selling the right to acquire the stock on or before a certain date, traders can generate an immediate income from the option’s premium to offset any potential losses as the position is being held. The strike price of the call option caps the position’s upside potential, but if the dividend is the primary reason for the trade, the potential upside isn’t a major concern for the trader.
In general, the position should be established about a week before the ex-dividend date by selling/writing call options that are set to expire within 10 business days of the ex-dividend date with an in-the-money strike price that’s roughly equal to the dividend’s value. The basic premise behind the trade is that the covered call option will be exercised just before the ex-dividend date and the trader will receive the premium – roughly equivalent to the dividend payout. If the stock doesn’t reach the strike price, the trader still collects the dividend.
Risks & Limitations
There are many important risks associated with the dividend capture strategy that traders should carefully consider before committing any capital:
- Tax Consequences – Qualified dividends are taxed at anywhere between 0% and 20% depending on an investor’s tax bracket. Unfortunately, short-term dividends don’t meet the requirements to be considered “qualified,” which means that they may be taxed at ordinary income rates of 22% to 37% or higher depending on the trader’s income.
- Transaction Costs – Traders must account for the cost of the transaction when determining the profitability of a dividend capture. While many brokers now offer commission-free trading, some traders may still pay fees that must be subtracted from the projected profit.
- Risk Exposure – Buying any stock entails the risk of downside movement and the same is true when using dividend captures. As a rule, traders should carefully consider the technical and fundamental merits of a stock before buying to capture a dividend and place appropriate stop-loss orders to limit their risk.
The Bottom Line
The dividend capture strategy involves purchasing a dividend-paying stock shortly before its ex-dividend date in order to capture the dividend and then selling it shortly thereafter. While the strategy sounds simple in theory, there are many important considerations that must be made to ensure that it’s profitable. Traders that are considering trading ex-dividend should carefully analyze each opportunity, ensure the proper protection is in place, and consider all of the tax consequences. But in the end, the strategy is a useful addition to any trader’s collection of trading strategies.
Frequently Asked Questions
How much does a stock typically drop on the ex-dividend date?
Stocks generally drop by approximately the dividend amount on the ex-dividend date. A stock paying a $0.50 dividend might open $0.50 lower. However, the actual drop can be more or less depending on market conditions, pre-market trading activity, and overall demand for the stock. The gap often fills within the same trading day for stocks with strong support levels.
What’s the minimum holding period to receive a dividend?
You must own the stock before the ex-dividend date to receive the dividend. Technically, you only need to hold it for one day (purchase before ex-dividend, sell on or after ex-dividend). However, to qualify for the lower qualified dividend tax rate, you must hold the stock for more than 60 days during the 121-day period surrounding the ex-dividend date.
Can dividend capture work with ETFs?
Yes, dividend capture can work with ETFs, though the dynamics differ slightly. ETFs typically have more predictable dividend schedules and may offer less price volatility around ex-dividend dates. However, ETF dividends are often smaller on a percentage basis, which can make the strategy less profitable after accounting for transaction costs and the bid-ask spread.