Profiting from Special Dividends: What Won’t Work, What Might

With the expectation of  tax changes next year some companies have been declaring eye popping special dividends, for example AOL is giving out $5.15  and Costco $7.  Intuitively it seems there should be some way to profit from these events, but as is always the case with Wall Street, there is never anything that approaches a free lunch.

At open on the ex-dividend day a stock will usually drop by about the dividend amount.  Of course general market conditions will influence stock prices too—sometimes overwhelming dividend related moves.  With AOL trading at around $37, the $5.15 dividend will amount to a 14% drop in the stock.

Three strategies come to mind to profit from this.  None will work.

1. Sell the stock short right before the ex-dividend date.
   •  On ex-dividend day: You make money on the stock dropping, but since you borrowed the stock for the short sale you are now on the hook for the dividend.  Unless the overall market drops, you will probably net out at a loss
2. Buy the stock and buy in the money puts on the stocks before it goes ex-dividend
   • On ex-dividend day: Your stock drops in value, you collect the dividend, and your puts stay the same or lose money.   Your puts will be adjusted by the option clearing house, either with a new strike price, or a cash payout you owe.  Because of the premium decay and possible volatility drop in your options overall you will probably lose money.  For more on option adjustment see this post.  For news on specific adjustments visit the Options Clearing Corporation Website.
3. Buy the stock and sell deep in the money calls before the stock goes ex-dividend
   • On ex-dividend day: Your stock drops in value, you collect the dividend, and your calls are adjusted to account for the special dividend.  Your net result will be probably be a small loss after commissions.

Three strategies that might be worth the trouble:

1. Buy the stock a day or two before the ex-dividend date and hope for a pre-ex-dividend run-up
   • Stocks will often rise in value right before the ex-dividend date.  Certainly not anything close to a big special dividend, but perhaps worth your trouble.   Have a target profit in mind.  I use a limit order to close out the position.
2. Buy the stock before ex-dividend and bet that the stock won’t drop by the full dividend amount
   • Oftentimes the stock won’t drop by the full dividend amount, or will bounce early (10% to 15% of the dividend value) in the morning after the initial drop.  Figure out how much profit you would be willing to live with and set sell limit orders before open on the ex-dividend date.
3. Buy the stock before ex-dividend and bet that some investors will forget to cancel their open buy limit orders.
   • In the case of a big special dividend there might be a lot of shares waiting to be picked off.  To have any chance at selling into these orders you will need to have your limit order in place before the market opens.  You won’t be able to put this order in place until after close the day before ex-dividend because your sell price will be below the bid price that the market closes at.    The book of buy orders won’t become active until the market opens—any high uncancelled orders will be picked off immediately.

For more on dividends see: Top 10 Questions about Dividends.

For more on dividend capture strategies see An Overview of Dividend Capture Strategies.