The dividend capture approaches that I describe below do work some of the time. My experience is that they expose the investor to excessive risk relative to the payoff–or they don’t pay off often enough.
- Buy and hold dividend paying stocks
- If you love the stock, this is a fine strategy, but then it really isn’t a dividend capture strategy. The dividend is just a bonus. If you don’t particularly like the stock, or don’t know much about the company / index then the price risk you assume typically swamps out the dividend.
- An advantage of this approach is that if you hold the stock long enough then you qualify for qualified dividends which currently have a lower tax rate. I prefer to do dividend capture in IRAs or other tax deferred accounts so the small gains aren’t ravaged by taxes.
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- Buy the day before ex-dividend and sell at closing
- Many dividend paying stocks do have a run-up the day before ex-dividend, but market risk makes this an iffy proposition.
- If the stock tanks due to market action it is tempting to not sell and at least collect the dividend, but this is often a bad idea. The stock will typically drop the amount of the dividend at opening regardless of the market conditions and if the day before was bad, the momentum is clearly negative. Investors that don’t follow the ex-dividend dates might conclude the stock is continuing to weaken and bail out.
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- Buy the stock a few days before ex-dividend and sell deep in the money calls options on the stock—hoping they won’t be exercised.
- This would be a fine strategy if the options market makers were stupid. Clearly they are not. Usually a few days before ex-dividend the premium available on the deep ITM calls drops to near zero, and they will almost certainly be exercised the night before the stock goes ex-dividend—leaving you with nothing.
- It is tempting to sell not-so-deep ITM options to get some premium up front. If the option expiration date is not close to the ex-dividend date this is generally a bad idea. If the premium is attractive then you typically are not very deep in the money—exposing you to market risk. Unless the underlying moves strongly up your options will probably not be assigned and then you will see a nasty jump in option premium starting at opening on the ex-dividend date—making it unprofitable to close out the position until near the option expiration date.
What about a buy/hold/sell combo?
If I own some shares of an XLU. I buy before exdividend and sell after the record date with a stop-loss to prevent a crash in the stock, I have a high probability of getting the dividend at low risk and if I continue to hold the stock also get the tax benefit and compounded dividends. Am I missing some risk or strategy? Seems like a high probability of success and great payout. What am I missing?
Hi Mojeaux, A security’s value drops by about its dividend value when it goes ex-dividend, so unless you hold the stock long enough for it to recover you haven’t gained anything. During that wait you’re exposed to market action. It’s not unusual for a security to drop more than a whole years worth of dividends in a few days. If you are ok with that risk, then fine. But look at a 5 year chart of XLU and see what can happen. Be careful with stop loss orders.. I don’t recommend them, flash crashes can trigger them and your order may fill at prices significantly below the limit you set.
— Vance
I guess I wasn’t clear enough. I know for a normal security that this is true (that it drops by the size of the dividend), but etf’s are usually price indexed…no? So an XLU etf which pays a dividend accumulated from it’s contents dividends and it’s price is set to that of it’s contents should be mostly unaffected by the payout. I have to check this but I don’t think there is a significant drop on it’s ex-dividend date. As for the volatility if I had a problem with volatility I wouldn’t trade. It’s all about risk and reward. I’ll run a simulation on XLU and let you know how it goes.
Hi Mojeaux, These indexes accrue the dividends as they are paid out and do drop when the ETF goes ex-dividend. Otherwise there would be risk-free money available–shorting the underlying stocks to XLU the day before ex-div (which presumably don’t go ex-div the same day as XLU ) and buying/holding XLU until ex-div. This is easy to see comparing SPY to IVV for example when they go ex-div within a few days of each other.
— Vance
I believe that an upcoming dividend tends to have a positive effect on a stock. Selling options against that stock is a good way to hedge against the major risk of the #1 or #2 strategy–a major negative move in the market that drops the stock. Unfortunately options aren't great for this sort of short term insurance. First of all, the option bid/ask spread, which for many stocks is $0.10 or more will discourage a quick sell / buy sequence. Deep ITM calls (approach #3) provides good insurance, but they negatively track the stock quite well an uptick in the stock is cancelled out, ATM calls will give you approximately half the gain, but they don't provide much insurance value, and OTM calls don't provide much insurance at all.
Selling ITM calls a few days before ex-dividend, with a premium around the dividend value, that expire within 10 days after the ex-dividend date is my preferred approach. Unless the market moves strongly against you the calls get assigned the night before ex-dividend. This avoids the bid/ask spread and limits your exposure to stock moves.
What about a combination of 2 and 3?
Selling options to get some cushion and increase the yield, but selling out before the ex-dividend date if/when the stock goes up the amount of the dividend. You don't actually get the real dividend, but you get the value of the dividend, which is really all you care about.
Of course, there's still risk involved, so you'd need to have a mental stop loss in place for when you would get out.
What about this? Long the stock the day before ex-dividend in a Roth IRA. Sell the next day at the open. Simultaneously, short the stock in a taxable account, buy back at the open. Theoretically, and I stress theoretically, you are flat on the stock, have a tax-deductible dividend payable in the short account — and a tax-free dividend in the long account. Pay $4 RT commissions for the trade. What am I left with? A free small tax deduction, if in a higher bracket or if dividends are to be treated as ordinary dividends. so whee am I wrong? Or is the IRS going to disallow the deduction, as a form of a wash sale?
Hi, I think this would work as you suggest. It might be best to wait a bit after opening to close out the positions, because ex-dividend openings tend to be messy and you want the close out prices to be very close. The short and long stock positions cancel, so it’s not particularly time sensitive. This article (http://www.fool.com/personal-finance/taxes/2002/12/06/dividends-paid-on-short-sales.aspx) is old, but it suggests you can’t write the dividend paid off as an interest expense–it may end up being added to your basis instead. This would convert it into a capital gain/loss situation. Your profit would be your marginal tax rate times the dividend payout minus commissions and any bid/ask spread losses. . In a traditional IRA the IRS would get their due when distributions are made, I don’t know how it would be treated with a Roth IRA.
— Vance