How to Use the Dividend Capture Strategy

The dividend capture strategy is an income-focused stock trading strategy popular with day traders. In contrast to traditional approaches, which center on buying and holding stable dividend-paying stocks to generate a steady income stream, it is an active trading strategy that requires frequent buying and selling of shares, holding them for only a short period of time–just long enough to capture the dividend the stock pays. The underlying stock could sometimes be held for only a single day.

Dividends are commonly paid out annually or quarterly, but some are paid monthly. Traders using the dividend capture strategy prefer the larger annual dividend payouts, as it is generally easier to make the strategy profitable with larger dividend amounts. Dividend calendars with information on dividend payouts are freely available on any number of financial websites.

Read on to find out more about the dividend capture strategy. This article will also cover some of the tax implications and other factors investors should consider before implementing this strategy into their investment plans.

Dividend Timeline

At the heart of the dividend capture strategy are four key dates:

• Declaration date: The board of directors announces dividend payment. This is the date when the company declares its dividend. It occurs well in advance of the payment.
• Ex-dividend date (or ex-date): The security starts to trade without the dividend. The day before the ex-dividend date is the last day to buy a stock and be eligible to receive the dividend payment. The ex-date is also the day when the stock price often drops in accordance with the declared dividend amount. Traders must purchase the stock prior to this critical day.
• Date of record: Current shareholders on record will receive a dividend. This is the day when a company records which shareholders are eligible to receive the dividend.
• Pay date: This is the day when the company issues dividend payments

How the Dividend Capture Strategy Works

Part of the appeal of the dividend capture strategy is its simplicity—no complex fundamental analysis or charting is required. Basically, an investor or trader purchases shares of the stock before the ex-dividend date and sells the shares on the ex-dividend date or any time thereafter. If the share price does fall after the dividend announcement, the investor may wait until the price bounces back to its original value. Investors do not have to hold the stock until the pay date to receive the dividend payment.

Theoretically, the dividend capture strategy shouldn't work. If markets operated with perfect logic, then the dividend amount would be exactly reflected in the share price until the ex-dividend date, when the stock price would fall by exactly the dividend amount. Since markets do not operate with such mathematical perfection, it doesn't usually happen that way. Most often, a trader captures a substantial portion of the dividend despite selling the stock at a slight loss following the ex-dividend date. A typical example would be a stock trading at $20 per share, paying a $1 dividend, falling in price on the ex-date only down to $19.50, which enables a trader to realize a net profit of $0.50, successfully capturing half the dividend in profit.

Using options contracts

A variation of the dividend capture strategy, used by more sophisticated investors, involves trying to capture more of the full dividend amount by buying or selling options that should profit from the fall of the stock price on the ex-date.

The dividend capture strategy offers continuous profit opportunities since there is at least one stock paying dividends almost every trading day. 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 implementations are compounded frequently. Though it is often best to focus on mid-yielding (~3%) large-cap firms in order to minimize the risks associated with smaller companies while still realizing a noteworthy payout.

Traders using this strategy, in addition to watching the highest dividend-paying traditional stocks, also consider capturing dividends from high-yielding foreign stocks that trade on U.S. exchanges and exchange-traded funds that pay dividends.

Real-World Example

As a historical example to illustrate dividend capture, on April 27, 2011, shares of Coca-Cola (KO) were trading at $66.52. The following day, on April 28, the board of directors declared a regular quarterly dividend of $0.47 cents, and the stock jumped $0.41 cents to $66.93. Although theory would suggest the price jump would amount to the full amount of the dividend, general market volatility plays a significant role in the price of the stock. Six weeks later, on June 10, the company was trading at $64.94. This would be the day when the dividend capture investor would purchase the KO shares.

On 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. Instead, it underlies the general premise of the strategy.

Tax Implications of Dividend Capture Strategies

Qualified dividends are taxed at either 0%, 15%, or 20%—depending on the investor's overall taxable income. Dividends collected with a short-term capture strategy fail to meet the necessary holding conditions to receive the favorable tax treatment and are taxed at the investor's ordinary income tax rate. According to the Internal Revenue Service (IRS), in order to be qualified for the special tax rates, "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.

Dividend Capture Strategies: Additional Costs

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.

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. In order to minimize these risks, the strategy should be focused on the 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, or 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 nimble portfolio managers as a means of realizing quick returns.

Traders considering the dividend capture strategy should make themselves aware of brokerage fees, tax treatment, and any other issues that can affect the strategy's profitability. There is no guarantee of profit. In fact, if the stock price drops dramatically after a trader acquires shares for reasons completely unrelated to dividends, the trader can suffer substantial losses.