Many years ago, unscrupulous brokers engaged in a sleazy sales tactic. They would advise their clients to purchase shares in a particular stock that was about to offer a dividend. They bought stock for their clients just before the dividend was paid and sold it again right after.
In theory, this may seem like a sound investment strategy, but it's a loser. The buyer would get the dividend, but by the time the stock was sold it would have declined in value by the amount of the dividend. The broker got the commission and the buyer might break even, minus the commission.
Why did the stock price decline right after the dividend was paid? Because that's the way the markets work.
- When a stock dividend is paid, the stock's price immediately falls by a corresponding amount.
- The market effectively adjusts the stock's price to reflect the lower value of the company, which could wipe out any gain sought by a short-term buyer.
- In addition, the buyer owes taxes on those dividends.
The Dividend Effect
A dividend is a distribution of a portion of a company's earnings paid to a class of its shareholders in the form of cash, shares of stock, or other property. It is a share of the company's profits and a reward to its investors.
For many investors, dividends are the point of stock ownership. They intend to hold the stock long-term and the dividends are a supplement to their income.
Dividends must be reported as taxable income.
Dividends also are a sign that the company is doing well. It has profits to share. It has, in fact, more cash than it needs and it can afford to share it with its stakeholders. That's why a stock's price may rise immediately after a dividend is announced.
However, on the ex-dividend date, the stock's value will inevitably fall. The value of the stock will fall by an amount roughly corresponding to the total amount paid in dividends. The market price has been adjusted to account for the revenue that has been removed from its books.
This loss in value is not permanent, of course. The dividend having been accounted for, the stock and the company will move forward, for better or worse.
Long-term stockholders are unfazed and, in fact, unaffected. The dividend check they just received makes up for the loss in the market value of their shares.
Thus, buying a stock before a dividend is paid and selling after it is received is a pointless exercise.
Why Don’t Investors Buy Stock Just Before the Dividend Date And Sell Right Afterwards?
Dividends and Taxes
To make matters worse, dividends are taxable. They have to be claimed as taxable income on the following year's income tax return.
Waiting to purchase the stock until after the dividend payment is a better strategy because it allows you to purchase the stock at a lower price without incurring dividend taxes.
Day Traders and Dividend Capture
Despite the downsides we've just discussed, there is a group of traders that are willing to undertake the risks involved with this dividend strategy—day traders. Day trading involves making dozens of trades in a single day in order to profit from intraday market price action. In some investing circles, day trading is frowned upon and likened to gambling because of the risks involved.
Day traders will use what's known as the dividend capture strategy, or a variation of it, to make quick profits by holding shares just long enough to capture the dividend the stock pays. The strategy requires the ability to move quickly in and out of the trade to take profits and close out the trade so funds can be available for the next trade.
Because day traders attempt to profit from small, short-term price movements, it's difficult to earn large sums with this strategy without starting off with large amounts of investment capital. The potential gains from each trade will usually be small. Potential losses, however, could be large. This is especially true if the trade moves against the investor during the holding period. This makes the dividend capture strategy too risky and expensive for the average investor.