Analyzing Dividend Capture Strategies

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 |  Includes: LLY, VZ
by: Hobbes Investment Research

A popular strategy among those investors who trade actively is dividend capture. There are several different ways to implement it, and I would like to go through some of them.

The last time to buy a stock and be eligible to receive its dividend is the day before ex-dividend day. That is, if ex-dividend day is December 15, one must buy the stock on December 14 (or the last trading day before December 15) at the latest. If you sell your stock on ex-dividend day, you are eligible for the dividend as long as you bought it, or exercised a call to buy it, the day before.

At the heart of every dividend capture strategy is the fact that on ex-dividend day, all other things being equal, a dividend paying stock opens lower than its previous close by the amount of the dividend. For example, a stock that closed at $50 a share on the day before ex-dividend and which pays a $0.50 dividend, should open, all things being equal, at $49.50 the next day. Given trading and other factors, in reality the stock may open substantially higher or lower than the previous close. The investor who wants to capture the dividend wants to buy the stock for $x and sell it for $x or higher. The dividend and the amount over $x is his profit, less commission costs and taxes.

(1)

The most common dividend capture strategy, and the worst, at least in bear markets, is to buy a stock shortly before ex-dividend day. As the stock trades on and after ex-dividend, its price will of course change. The investor who bought the stock for the dividend in this first way will want to proceed in one of two ways after holding the stock overnight. The investor will either (a) sell the stock immediately after it reaches or exceeds the price at which the investor bought it, or (b) he will wait at least 61 days and then try to sell it for the price he paid or higher. In both cases, the investor uses the sale proceeds to move on to the next dividend paying stock. He will receive the dividend payment on the pay date, which for most stocks is usually a month from ex-dividend day. The person who does (a) potentially has access to his money much faster, thus being able to put it back to work more quickly. In some cases, the dividend paying stock can be sold on ex-dividend day for a profit. However, the dividend this person receives is taxed as ordinary income. The person implementing (b) will optimally sell for a profit right after holding the stock for 61 days. This person can receive up to six dividend payments on the same sum of money per year and be taxed at the qualified dividend rate. If strategy (a) can be implemented successfully on a regular basis, it is likely better than (b) in terms of after tax profits.

Critics of strategy (1) often say the dividend capture is a myth. I am inclined to agree, especially with regard to (a). What the investor is really doing is trying to get a capital gain. It is the stock's move up after ex-dividend that results in the profit. This is the same as buying any stock, not necessarily dividend paying, at any time and waiting for it to go up some specified amount before selling it. Strategy (b) has more right to be called a dividend capture strategy, but it too relies on capital gains in order to be successful.

With both strategies there is no guaranty whether the stock will go back up to the price the investor paid for it. There is also no guaranty over how long it will take for the stock to go back up. Sometimes it never does.

(2)

Another dividend capture strategy is one that I have implemented with some success. It involves buying a stock before ex-dividend day while simultaneously selling a deep in the money call. The trick is to find a call whose delta is as close to 1 as possible and whose premium at least compensates you for all your transaction costs should the stock be called before ex-dividend day (exercise notices are accepted until 4:30 P.M. Central Time). Just like the first strategy, this second strategy has two types. The investor sells the stock and buys back the call either (a) on or immediately after ex-dividend day.

From the IRS:

Holding period reduced where risk of loss is diminished. When determining whether you met the minimum holding period discussed earlier, you cannot count any day during which you meet any of the following conditions.

  1. You had an option to sell, were under a contractual obligation to sell, or had made (and not closed) a short sale of substantially identical stock or securities.

  2. You were grantor (writer) of an option to buy substantially identical stock or securities.

  3. Your risk of loss is diminished by holding one or more other positions in substantially similar or related property.

Why the highest delta? The higher the call's delta, the more likely it will move along with the stock. For example, if the stock goes up by $2 per share, the call whose delta is close to 1 should also go up by $2. If the stock falls by $2, the call should fall by $2. The higher the delta on the call, the more likely it is that one can exit the position for the same price that one entered into it, regardless of the stock's price movement (provided it doesn't fall too sharply, in which case the call might be more expensive compared to the stock's price if it becomes in or out of the money).

Here's an example. Stock XYZ trades at $30 a share on the day before ex-dividend day. It is supposed to pay a $0.40 a share dividend, and the pay date is a month from now. At the same time, a 5 strike call is trading for $25.20. (This is rare, but it does happen). The investor proceeds to enter a multi-leg order, usually called a "buy write" on the order screen of his brokerage account (strategy (2) is not worth doing without a multi-leg order; that is, if you have to make two separate transactions, you might lose money if the prices change too quickly). This order has two legs, one to buy the stock and one to sell the call. In leg one, the investor enters buy 100 shares of XYZ. In leg two he enters sell to open 1 XYZ 5 strike call. Where he specifies the price, the investor enters a net debit of 4.8. If the order is filled, the investor will receive 100 shares of XYZ into his account and he will be short 1 call, while $480 (plus commissions) leaves his account.

The next day, ex-dividend day, if the investor's shares haven't been called, he will enter into another transaction. He will proceed to the same screen on his brokerage account, except now he will sell 100 shares of XYZ in leg one and buy to close 1 call in leg two. Where he specifies the price, he will enter a net credit of at least 4.8. If his order is filled at 4.8, he will receive $480 in his account (less commissions), he will no longer have the XYZ shares, and he won't be short the XYZ call. A month later, he will receive XYZ's dividend of $40. This, minus commissions and taxes, is his profit from the entire enterprise. If he is able to reverse his position for a higher net credit than his debit, this will add to his profit.

Note that the stock's price action does not matter unless it goes down substantially. If XYZ went up by $5 a share to $35 during the two days, the call would also go up by $5 to at least $30. If the stock went down by $6 to $24 a share, as another example, the call would go down by $6 to around $19.

Why the deepest call possible? Two reasons. First, the deeper in the money the call is, the more protection the investor has against an adverse stock movement (in this case down). The investor does not lose money unless the stock goes below his net debit. In the example above this would be XYZ going below $4.80 per share. Second, since only the net debit leaves the investor's account, the dividend can be greatly leveraged. Notice that in the example above it cost the investor $480 to receive a $40 dividend, less commissions. An investor using strategy (1) above would have to put $3,000 at risk (if XYZ is trading at $30 per share) to get the $40 dividend. The investor in strategy (2) can buy 600 shares for less than $3,000, and the dividend he would receive would be $240, less commissions. Now that's leverage, and very low downside risk.

It is important to note that calls are most likely to be exercised early the day before ex-dividend day. This is why it is necessary to find a call that offers a premium, so that if the shares are assigned early the premium compensates the investor for his transaction costs and may even leave some profit. To be worthwhile, the net debit of the transaction must be below the call's strike by at least the amount of all the broker fees the investor will incur.

I believe (2) can more appropriately be called dividend capture than strategy (1), as the strategy seeks to minimize all potential capital gains and losses. The main source of profit is the dividend payment.

(3)

Along the same lines as strategy (2), but with no leverage at all and with the expenditure of more money but almost no risk, the investor buys the dividend paying stock the day before ex-dividend day while at the same time buying an in the money put. The deeper in the money the put is, the more likely the investor will receive an advantageous price for it. Just as in (2), the investor's aim is to enter and exit the transaction for the same price. That is, the net debit for entering the transaction should equal the net credit for exiting it. The dividend received, minus transaction costs and taxes, is the profit.

Here's an example. Stock XYZ trades at $30 a share. The 50 strike put trades at $20. Before ex-dividend day, the investor enters a multi-leg transaction on his brokerage screen, typically called a "protective put." In leg one he enters buy 100 shares of XYZ. In leg two he enters buy 1 XYZ 50 strike put. Where he specifies the price, he enters 50. If his order is filled, $5,000 will leave his account (plus commissions) and he will receive 100 shares of XYZ and 1 XYZ 50 strike put. On ex-dividend day or after, the investor will either attempt to close out his position by doing the same multi-leg order in reverse--sell 100 shares and sell 1 put--for a net credit of 50 or more, or he will exercise the put, whichever is cheaper in terms of commissions, unless the net credit is sufficiently over his original debit to give a profit, in which case he will do the multi-leg order.

For example, if the investor can sell the shares and put for a credit of 51, he will earn an extra $1 per share of profit (less commissions). In the worst case, the investor will exercise his put. That is, in the worst case, the investor will receive the $5,000 back into his account, no matter what the stock does. On the pay date, he will receive the dividend, which will be his profit, less commissions and taxes.

Note that here there are no adverse stock moves. Suppose XYZ goes to $0. The investor can exercise his put and get his $5,000 back. Or suppose the stock goes above $50 a share. The investor can still get his $5,000 back, but if the stock rises enough, he can get more. For example, suppose XYZ goes to $50 per share. The investor will now be making $20 per share on the stock. If the put is worth more than $0, which it should be since it's at the money, the investor will receive more than $5,000 in closing out his position by selling the stock and put. As another example, suppose XYZ goes up to $100 per share. The investor will make $70 per share on the stock, but the put will probably be worthless. Still, he'll make $5,000 by selling the stock. That is, he'll receive $10,000 for selling XYZ, resulting in a $5,000 profit.

As this dividend capture strategy is a no lose situation (except if the stock doesn't pay the dividend, in which case the most one can lose is commission costs), in the money put sellers have long factored in the dividend. It is rare when one can find a stock trading at $30 with a 50 strike put trading at 20. This happens occasionally, but more likely than not the put will be more expensive.

Thus, strategy (3) is only worthwhile if the dividend payment will cover all commission costs and taxes and the difference between the strike minus the stock price and what the put is trading for. That is, suppose XYZ pays a $0.40 dividend and is trading at $30 on the day before ex-dividend day while the 50 strike put is trading at $20.10. The transaction will cost the investor $50.10 per share plus commissions. Let's say all commissions, for entering and exiting the position, equal $0.10 per share. That means that the entire transaction will cost the investor $50.20 per share, or, if this is for 100 shares, $5,020. Implementing strategy (3) in this case would still be worthwhile, because the dividend is $0.40 per share. Here, the investor's profit would be $0.20 per share, or $20. This does not factor in taxes, which would be based on the entire $0.40 dividend and which would be charged at the ordinary income rate if the investor exits the position within 61 days of entering into it.

Here is a real life example. Eli Lilly (NYSE:LLY) is going ex-dividend on February 11. It will pay $0.49 a share on March 10. It closed today at $37.47 per share. The 55 strike April put has a bid of 17.80 and an ask of 18.10.

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Suppose that the put can be bought for 17.95 and the stock can be bought for $37.47. Buying 100 shares for $37.47 and the put for $17.95, gives the investor a net debit of 55.42. If he enters into this transaction today, the worst that can happen is he'll get a credit of $55 per share when he exercises the put on or after February 11. This gives him an up front loss of $0.42 a share. The dividend, however, is $0.49 per share. Excluding commissions and taxes, the transaction would give a profit of $0.07 per share. If commissions and taxes are less than $0.07 per share, the transaction will be profitable. The risk would be $0.42 per share plus commissions if Eli Lilly does not pay the dividend.

If he has a lot of money to work with and his commission and tax costs are low (say this is an IRA account with cheap commissions, and/or the broker is offering free trades as a promotion), the transaction may be worth doing for the investor.

The above assumes that the position is closed by exercising the put. It is possible that the difference between the stock price plus the put price and the strike price (in our LLY example $0.42) will stay the same or change in the investor's favor. If this is true, the investor's profit can potentially be $0.49 or even greater. That is, the $0.07 above, minus commissions and taxes, is the minimum profit the investor will receive as long as LLY pays the dividend.

Note that it might be better to start early. When I looked at this same transaction two weeks ago, the minimum profit was $0.17, based on the put's ask price. The ex-dividend date's approach (along with more market volatility) has made puts more expensive, it seems.

If there is still a profit after taxes and commissions, and the investor has a lot of money to work with, he can potentially make a consistent and practically risk free return on the same sum of money every day. That is, the transaction is entered into on Monday before XYZ goes ex-dividend on Tuesday. The position is closed on Tuesday, and the proceeds are immediately invested into ABC, which is going ex-div on Wednesday. The ABC position is closed on Wednesday and the investor immediately invests the proceeds into ZYX, which goes ex-dividend on Thursday. And so on. It is hard work, but it may be very worthwhile, for there is practically no risk.

Note that in strategy (3), it is OK if the net debit exceeds the strike price, as long as the dividend more than covers the difference and all the costs. Unlike in strategy (2), there is no risk for the investor of losing his shares. This is because as the option holder he controls whether and when the option is exercised, so long as the option's expiration date is after ex-dividend day.

Just like strategy (2), the profit for strategy (3) comes from the dividend minus transaction costs. It is therefore more appropriately called a dividend capture strategy than (1). For tax reasons, strategies (2) and (3) are best implemented in a tax sheltered account. Most broker IRA accounts allow covered calls. Protective puts should also be allowed, but each broker has its own policies.

Variations on the Above Three Strategies

(4)

One variation on strategy (1) is take advantage of the difference between a deep in the money call's price plus the strike and the price at which the stock is trading. Typically, assuming there are no commission expenses, it is cheaper to buy a deep in the money call and exercise it than it is to buy the stock. For example, Verizon (NYSE:VZ) is trading at $30.62 as I'm writing, while the January 2010 5 strike call has a bid of 25.45 and an ask of 26. If I can buy the call for under 25.62, it is more worthwhile for me to do so and immediately exercise the call than it would be to buy the stock, if we assume there are no commissions. Suppose I am able to buy the call for 25.50. When I exercise it, an additional $5 per share exits my account, and I end up buying the stock for $30.50 per share, $0.12 lower. Doing this before ex-dividend day offers a little protection over strategy (1). The investor, just as in (1), hopes the stock will go up by at least the amount of the dividend on or soon after ex-dividend day. The profit will be the few cents earned on the call along with the dividend payment to be received, minus transaction costs and taxes.

Generally, retail investors' commission costs prohibit this strategy. Institutional investors, or those with little or no commission costs engage in this activity all the time. I have a feeling (but no proof) that retail brokers fleece some of their customers in this way. For example, say someone implements strategy (2). If on ex-dividend day the stock is up in pre-market, the broker takes away the customer's shares and sells them on the open market, pocketing the dividend and the commissions, and telling the customer that his shares were called away the day before. It is as if the broker implemented strategy (4). If the stock is down in pre-market, the broker lets the customer keep the shares. There are complications, but this font running scheme seems pretty feasible and I wouldn't be surprised if it is conducted. But like I said, I have no proof. If I ran a crooked Wall Street outfit (is that redundant?), I might do something like this to make a few extra bucks.

(5)

Another variation on strategy (1) is to combine (4) with (2). That is, it involves buying deep in the money calls and exercising them at the same time as selling other or same strike in the money calls and hoping these are not exercised. While the optimal time to exercise a call option early is the day before ex-dividend day, some number of calls are not exercised. This may be because the call holder forgets, doesn't have enough money to do so, or doesn't think it's worthwhile.

Just as in (4), institutional investors frequently engage in this activity. Commissions usually make this strategy cost prohibitive for individual investors.

(6) and (7)

Do the same thing as strategies (2) and (3), but use margin to get more shares than you could otherwise afford by using cash only. Profit is increased by the extra dividends received, minus the margin borrowing rate and the extra commissions for selling or buying more option contracts.

This is for educational and entertainment purposes only. Some of the risks may not have been mentioned or accurately described. Use these strategies at your own peril.

Disclosure: At the time of writing, I did not own any securities mentioned above. VZ is in my buy and hold forever dividend stock portfolio.

Editor's note: The original version of this article contained an error, by stating that a dividend will be taxed at the qualified tax rate if an investor buys a dividend paying stock and a put option on it and holds it for 61 days. This has since been corrected.