How to Use the Dividend Capture Strategy (2024)

The dividend capture strategy is an income-focused stock trading method popular with day traders. While traditional approaches tend to buy and hold stable dividend-paying stocks to produce a steady income stream, this strategy requires frequently trading shares and then holding them for only a short period, long enough to capture the dividend that the stock pays. You might hold the stock for just a single day.

Dividends are commonly paid annually or quarterly, but some are paid monthly. Traders using the dividend capture strategy prefer larger annual dividend payouts, as making the strategy profitable with more significant dividend amounts is generally easier. The dividend calendars with the relevant information on dividend payouts are available on various financial websites.

Read on to learn more about the dividend capture strategy, its tax implications, and other factors before considering it for your trading goals.

Dividend Timeline

The dividend capture strategy relies on four key dates:

• Declaration date: The board of directors announces the dividend well before it’s paid.
• Ex-dividend date: Also called the ex-date, the security begins trading without the right to dividend of the month or year, depending on when it’s paid. The day before the ex-dividend date is the last day to buy the stock and be eligible for the payment. The ex-date is also when the stock price usually drops in line with the declared dividend amount.
• Date of record: This iswhen a company logs which shareholders are eligible to receive the dividend.
• Pay date:This iswhen the company issues its dividend payments.

How the Dividend Capture Strategy Works

Part of the appeal of the dividend capture strategy is its simplicity—no complex fundamental analysis or charts are required. An investor only needs to buy shares of a stock before the ex-dividend date and sell them on or after the ex-dividend date. If the share price falls after the dividend announcement, the investor might wait untilthe price returns to its original value. Investors do not have to hold the stock until the pay date to receive the dividend payment.

Theoretically, the dividend capture strategy shouldn’t work. If markets operated with perfect efficiency, the share price would reflect the dividend amount until the ex-dividend date, when the stock price would fall by the dividend amount. Since markets do not run with such mathematical perfection, this doesn’t usually happen. More often, a trader captures a significant part of the dividend despite selling the stock at a slight loss following the ex-dividend date.

For example, suppose a stock trading at $20 per share pays a $1 dividend but then falls in price on the ex-date to $19.50. This enables a trader to pocket a net profit of $0.50, successfully capturing half the dividend.

Using Options Contracts

A variation of the dividend capture strategy, used by more experienced investors, involves trying to capture more of the total dividend amount by buying or selling options that should profit from the stock price fall on the ex-date.

The dividend capture strategy offers continuous opportunities for profit because, on each trading day, at least one stock is paying dividends. A significant holding in one stock can roll over into new positions, capturing dividends at each stage along the way. With a substantial initial capital investment, investors can take advantage of yields large and small, as returns would be compounded often. However, it is typically best to focus on mid-yielding (about 3%) large-cap firms to lower the risks associated with smaller companies while still realizing a noteworthy payout.

Traders using this strategy keep an eye on the highest dividend-paying traditional stocks while also considering capturing dividends from high-yielding foreign stocks traded on U.S. exchanges and exchange-traded funds (ETFs) that pay dividends.

Real-World Example

Let’s take a real example from trading history. Coca-Cola (KO) shares were $60.57 on July 18, 2023. The following day, July 19, the board of directors announced a regular quarterly dividend of $0.46, and the stock jumped $1.07 to $61.64. Although theoretically, the price jump should equal the dividend, general market volatility plays a significant role in the stock price. The company was trading at $58.40 54 days later, on Sept. 12. This was the day the dividend capture investor would buy shares in KO.

On Sept. 14, the dividend was declared, and the share price rose to $58.43. This would be the exit point for the trader, who not only qualified for the dividend but also realized a capital gain. Unfortunately, this scenario does not consistently occur, but it does show why the strategy is in use.

Tax Implications of Dividend Capture Strategies

Qualified dividends are taxed at 0%, 15%, or 20%, depending on the investor’s overall taxable income. Dividends collected with a short-term capture strategy wouldn’t meet the holding conditions to receive favorable tax treatment and are taxed at the investor’s ordinary income tax rate. According to the Internal Revenue Service, to qualify for special tax rates, “you must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.”

Taxes play a significant role in reducing the potential net benefit of the dividend capture strategy. Nevertheless, an investor can avoid taxes on dividends if the capture strategy is done through an individual retirement account (IRA).

Dividend Capture Strategies: Additional Costs

Transaction costs further reduce the realized returns of this strategy. Suppose a declared dividend is 50 cents, and the stock price goes down 40 cents. Apart from taxes, only 10 cents are realized per share. Transaction costs to buy and sell the securities may add additional costs, reducing the effectiveness of this strategy. Large positions are often necessary to benefit from the strategy’s full potential.

The potential gains from a pure dividend capture strategy are typically small, while possible losses can be considerable if a negative market movement occurs within the holding period. A drop in stock value on the ex-date exceeding the dividend could force the investor to maintain the position for an extended period, introducing systematic and company-specific risks into the equation. Adverse market moves can quickly cut any potential gains from this dividend capture approach. To minimize these risks, the strategy should focus on the short-term holdings of large blue-chip companies.

Pros and Cons of the Dividend Capture Strategy

On the positive side of the dividend capture strategy is the possibility that it can deliver quick returns and your capital isn’t tied up for long periods. It can also be widely applied since there are thousands of dividend-paying companies, allowing investors to use this strategy in diverse markets. In addition, the strategy could produce regular income from dividends, making it appealing to income-focused investors.

However, the strategy also carries several downsides. There are tax implications to consider, as dividends received beyond a certain threshold are taxable. In some jurisdictions, dividends are taxed at a higher rate if the shares aren’t held for a specific period. Another risk is price fluctuations; all dividend stocks will often drop in value on the ex-dividend date, usually by about the amount of the dividend. If the stock price doesn’t rebound quickly, you may have a net loss. Finally, the strategy requires routinely buying and selling shares, which can lead to high transaction costs that would eat into the profits.

The Bottom Line

Dividend capture strategies provide an alternative investment approach to income-seeking investors. Proponents of the efficient market hypothesis claim that the dividend capture strategy is ineffective. This is because stock prices should rise by the dividend amount in anticipation of the declaration date or because market volatility, taxes, and transaction costs mitigate the opportunity to find risk-free profits. Meanwhile, nimble portfolio managers often use this technique to realize quick returns.

Traders considering the dividend capture strategy should understand how brokerage fees, tax implications, and other issues affect the strategy’s profitability. There is no guarantee of profit. If the stock price drops dramatically after a trader acquires shares for reasons unrelated to the dividend, the trader may be left holding substantial losses.