Wouldn’t it be great if you could grab a dividend without taking the risk of holding the shares long term?
After a tumultuous 2018, the FTSE 100 has a forecast dividend yield of 4.7% and payments are predicted to reach record levels in the year ahead.
So, it’s a great time to be a dividend investor, but of course, you are still susceptible to movements in the underlying shares. And with the ever-present threat of a hard Brexit, it would be foolish to predict plain sailing ahead.
However, there is a strategy you can attempt that aims to grab the dividend, whilst eliminating the longer-term risk of holding shares.
It’s called dividend capture.
Before we dig in though, a quick review of the dividend cycle is required.
The key dates
When a public company’s board of directors decide that they are going to pay a dividend to the shareholders, they are required to publish the details. The announcement covers the amount to be paid and includes three important dates.
Firstly, the date of the announcement itself. This is called the declaration date.
Secondly, the record date. This is the date that a shareholder’s name must be on the share register in order to receive the dividend. In the UK, it is usually a Friday.
And thirdly, the date that they will actually pay the dividend to shareholders. This is called the payment date andis usually several weeks after the record date.
A fourth date is derived from the record date, and it’s the most important one for us to consider — the ex-dividend date.
This is the first date when a purchaser of the shares is not entitled to the dividend. If the record date is a Friday, then the ex-dividend date is the Thursday immediately before.
Apologies, if all that makes your head spin.
It’s actually pretty easy to work out, when you understand why the dates stack up the way they do.
In the UK, it takes two business days for a share transaction to settle — that’s T+2 in the lingo. In other words, if you buy a share today, your name will appear on the register in two business days’ time.
So, if the record date is a Friday, you need to buy your shares on the Wednesday to make sure that your name will appear on the register in time — and therefore ensure your entitlement to the dividend.
If you waited until Thursday to buy your shares, then your name would not be on the register until the following Monday. Therefore, the previous owners name would still be on the register on the Friday, and they would receive the dividend — not you. Hence, it is called the ex-dividend date.
If you are still confused, don’t worry. Here is a simple rule:
The ex-dividend date for a public company is widely publicised. Just make sure that you buy your shares before that date, if you want to receive the dividend.
The dividend capture strategy is quite simple to understand, but harder to pull off.
The idea is that you buy the shares in your target company immediately before the ex-dividend date and then sell them either on the ex-dividend date or shortly afterwards.
By buying shares before the ex-dividend date, your name is on the register at the record date and you will receive the dividend. Then, by quickly selling the shares, you alleviate the risk of holding them long term.
That sounds like a perfect strategy for an income investor. But of course, it’s not quite that simple.
In theory, when a stock trades ex-dividend its price will drop by an amount equivalent to the dividend.
That makes sense. If you buy a 1,000p share the day before it goes ex-dividend then you are entitled to a dividend of, for example, 40p.
However, if you bought the same share the next day, it will have gone ex-dividend, and — in theory — its share price will have dropped by 40p to 960p. That would ensure that the price you paid was the same as if you had bought it the previous day and received the dividend.
However, in practice, this exact movement in the share price seldom occurs and that is why this strategy can work.
Proponents of dividend capture anticipate that the stock will not fall as far as expected. Or, that it will often bounce back to its prior level within a few days.
So, for example, if the shares open at 980p on the ex-dividend date, you could immediately sell them and take a 20p loss. But, that loss is less than the 40p you have made on the dividend you captured and so you are up 20p overall. Job done.
By repeatedly targeting shares that are about to go ex-dividend you can collect a continuous stream of dividends without ever holding onto the shares for more than a few days.
You didn’t really expect it to be that simple though, did you?
There are a number of issues with the approach.
The most important, is that you do not know at what price the shares are going to trade on the ex-dividend date.
Like every other day of the year, their price is affected by a whole host of factors that have nothing to do with the dividend. Specific news about the company, or the economy as a whole, can easily override the effect of the dividend.
It is quite possible for the shares to open above the previous days’ purchase price and for you to capture the dividend and make a profit on the shares.
Or, they could open down by an amount greater than the dividend and you are forced to sell your shares for a loss that is bigger than the dividend payment. Nothing is guaranteed.
Of course, the price of the share will bounce around on the ex-dividend date and the subsequent trading days. So, you may still be able to exit the trade at a profit by hanging fire and picking an optimal time to sell.
There is also an argument that demand for shares tends to rise in the run up to an ex-dividend payment. As more investors buy-in, so they can collect the pay-out, the extra demand can push the price of the shares up.
Just at the point that you are planning on buying them — that’s not ideal.
And don’t forget your costs. You will need to pay commissions to buy and sell the stock and — if you are buying UK shares — you will also need to include the 0.5% stamp duty on purchases.
Also, depending on your personal investment circumstances, there may well be tax to pay on the dividend and CGT on the shares.
Make sure you include all these costs in your calculations.
The bottom line
It is certainly possible to capture dividends in this way and generate a sustainable income.
However, you will need to do your research and develop rules for dealing with the various possible outcomes. As trading strategies go, it is pretty straightforward and does not require a great deal of research into the individual companies.
But maybe, you just want a simple life and this all sounds like a lot of hard work.
In that case, how about joining me for my monthly dividend recommendations in Income For Life . I do all the heavy lifting for you, and even throw in a long term covered call to really boost the income yield.