The dividend capture strategy is based on an investment technique that focuses on quickly capturing the dividend issued by a corporation, without intending to hold the investment over a long period of time.
The dividend timeline below illustrates the four dates investors must understand and monitor in order to effectively implement the dividend capture strategy. (Understanding the dates of the dividend payout process can be tricky. We clear up the confusion. To learn more, read Dissecting Declarations, Ex-Dividends And Record Dates.)
|Figure 1: Dividend Timeline
Declaration Date – Board of directors announces dividend payment
Ex-Date (or Ex-Dividend Date) – The security starts to trade without the dividend
Date of Record – Current shareholders as on record will receive dividend
Pay Date – Company issues dividend payments
TUTORIAL: Electronic Trading
Dividend Capture Overview
In contrast to other more common dividend income strategies that center on holding stable dividend paying stocks to generate a steady income stream, dividend captures typically are executed with a short term time horizon where the underlying stock could sometimes be held for only a single day.
The basic dividend capture strategy involves purchasing shares of stock prior to the ex-date followed by a subsequent share sale. Prior to the ex-date, the stock price reflects the expected dividend payment. Because investors purchasing the stocks on the ex-date no longer receive the dividend, the share price should theoretically fall by the price of the dividend amount. In practice this does not always happen. Depending on the price movement, shares are then sold immediately on the ex-date or when the price bounces back to its original value.
One of the primary advantages of the dividend capture approach to trading is that there are numerous companies that pay dividends on a daily basis. Therefore, a large holding in one stock can be rolled over regularly into new positions, capturing the dividend at each stage along the way. With a substantial initial capital investment, investors can take advantage of small and large yields as returns from successful implementation are compounded frequently. Having said that, it is often best to focus on mid-yielding (~3%) large cap firms in order to minimize the risks associated smaller companies while still realizing a noteworthy payout. Another important attraction is the lack of fundamental analysis required to execute the relatively simple strategy.
Dividend Capture Examples
A hypothetical share could be trading at $20 before the ex-date and the shareholders are entitled to an upcoming quarterly dividend of $0.25. On the ex-date, the price of the stock should drop to $19.75 but those investors only buying the shares now are no longer entitled to the dividend distribution. Basically, an investor can buy the stock for $20, hold it for one day and sell it on the ex-date for $19.75 and still receive payment on the payment date. The potential to generate quick access returns stems from the phenomenon whereby the stock fails to fall to $19.75 as theory would suggest, and even when the predicted fall actually does occur, the shares recoup their value shortly thereafter.
On April 27, 2011 shares of Coca Cola (NYSE:KO) were trading at $66.52. The following day, on April 28, the board of directors declared a regular quarterly dividend of 47 cents and the stock jumped 41 cents to $66.93. Although theory would suggest that the price jump would amount to the full amount of the dividend, general market volatility plays a significant role in the price effect of the stock. Six weeks later, on Friday June 10, Coca Cola was trading at 64.94 - this would be the day when the dividend capture investor would purchase the KO shares.
The following Monday, June 13, the dividend was declared and the share price rose to 65.12 - this would be an ideal exit point for the trader who would not only qualify to receive the dividend, but would also realize a capital gain. Unfortunately this type of scenario is not consistent in the equity markets, but it underlies the general premise of the strategy. (Explore arguments for and against company dividend policy, and learn how companies determine how much to pay out. Check out How And Why Do Companies Pay Dividends?)
Dividend Capture Shortfalls
Qualified dividends are taxed at either 0% or 15% depending on the tax status of the investor. Dividends collected with a short term dividend capture strategy fail to meet the necessary holding conditions to receive the favorable tax treatment and are therefore, taxed at the investor's ordinary income tax rate. According to the IRS, in order to be qualified for the 0/15% tax rate, "you must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date." Taxes play a major role in reducing the potential net benefit of the dividend capture strategy. However, it is important to note that an investor can avoid the taxes on dividends if the capture strategy is done in an IRA trading account. (Find out how legislation enacted in 2003 is benefiting both investors and corporations, and when it's scheduled to expire. See Dividend Tax Rates: What Investors Need To Know.)
Transaction costs further decrease the sum of realized returns. Unlike the Coke example above, the price of the shares will fall on the ex-date but not by the full amount of the dividend - if the declared dividend is 50 cents, the stock price might retract by 40 cents. Excluding taxes from the equation, only 10 cents is realized per share. When transaction costs to purchase and sell the securities amount to $25 both ways, a substantial amount of stocks must be purchased simply to cover brokerage fees. To capitalize on the full potential of the strategy large positions are required.
As addressed in the above discussion, the potential gains from a pure dividend capture strategy are typically small while possible losses can be considerable if a negative market movement occurs within the holding period. A drop in stock value on the ex-date which exceeds the amount of the dividend may force the investor to maintain the position for an extended period of time, introducing systematic and company specific risk into the strategy. Adverse market movements can quickly eliminate any potential gains from this dividend capture approach. Such risks are present with all trading/investing strategies. In order to minimize these risks, the strategy should be focused on short term holdings of large blue chip companies.
The Bottom Line
Dividend capture strategies provide an alternative investment approach to income seeking investors. Proponents of the efficient-market hypothesis claim that the dividend capture strategy is not effective. This is because stock prices will rise by the amount of the dividend in anticipation of the declaration date, because market volatility, taxes and transaction costs mitigate the opportunity to find risk-free profits. On the other hand, this technique is often effectively used by top performing portfolio managers as a means of realizing quick profits. The ultimate test of the success or failure of this strategy is whether or not it will work for you. (For related reading, see Digging Into The Dividend Discount Model.)