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For example, if XYZ stock is trading at $100, it will trade at $99 after paying a $1 dividend. Empirical evidence shows that when a stock goes ex-dividend, the stock usually trades above it's ex-dividend price. A $100 stock that pays a $1 dividend will trade above $99 at the open most of the time.
Profiting from this requires that the stock is purchased at the close
of trading the day before a stock goes ex-dividend. The stock must be
sold the following day, the ex-dividend day, immediately at the
open.
Just how much can be made by trading dividends depends on how much the
stock trades above the ex-dividend on the open. Statistically, stocks
paying more than 3% annualized lose only 72% of their dividend value
when the market opens on the ex-dividend date.
Consider $100,000 worth of stock paying a quarterly dividend with a 4% annual yield. A quarterly dividend payment would equal $1000. Theoretically, the value of this stock would drop to $99,000.
If this stock loses only 72% of it's dividend value, the value of the stock would drop to $99,280. The holder of the stock would incur a capital loss of $720, then receive $1000 on the dividend pay date, for a net profit of $280.
The cost of the round trip trade must be deducted from the transaction, and that would diminish the overall return.
A significant benefit of trading dividends is the potential tax benefit. Dividend income is taxed at 15%, while the capital loss incurred can be deducted at the marginal tax rate. This rate varies depending on your tax bracket. A taxpayer subject to a 33% marginal tax rate would have the added benefit of paying a tax rate reduced by 18% on the $1000 dividend.
In the above example trade, the immediate benefit would be $280 less commissions, and the deferred benefit would be 18% of $720. Although this return on investment may appear small, the benefit can be realized frequently, and the aggregate of these trades can be significant.
Disadvantages of trading dividends are:
- A lot of capital must be put at risk for a relatively small return. There are strategies to reduce or eliminate this risk using options (see the next section). The idea of being subject to overnight risk can be unacceptable to most experienced traders.
- The dividend distribution is unavailable during the period between the ex-dividend date and the pay date.
- Implementing this strategy requires tracking dividend payments
- Trades must be made at the close of trading and again at the open each time a dividend play is made, requiring the trader be available to trade at frequent intervals.
The advantages are:
- The net capital loss is usually less than the dividend payout
- Reduced tax liability, since dividends are taxed at a lower rate than than capital gains
- Deferred tax liability, if the pay date is in the calendar year following the ex-dividend date
There are guidelines for trading dividends:
- set the minimum yield that will result in a profit. This number is relative to the capital at risk.
- Buy the dividend bearing security as near to the market close the day before ex-dividend date as possible.
- always trade with a market order
- get out at the open on the ex-dividend date with a market order
- do not place a market order before the open