With dividend season approaching, it’s always good to remain mindful of one the market’s favourite trading strategies.
Everybody wants to take advantage of dividends, but you don’t need to hold a stock for the entire year to reap the rewards of these payments.
In fact, you can hold a stock for less than 24 hours and still be entitled to receive dividend payments. This is what the dividend stripping strategy is all about, but to do it correctly, you’ll need to hold the stock for longer than 24 hours.
Dividend stripping is a strategy in which you can take advantage of a share’s dividend, the associated franking credit (if the company offers them) and, if you manage the trade correctly, even the benefit from a capital gain.
The dividend low down
There are a few basics that traders need to remember at dividend time.
A company will usually announce its actual dividend amount at the time it reports profits. At this time, the company will also announce the “ex-dividend date” along with the record date and the payment date.
For traders looking to participate in some dividend stripping, the most important date is the ex-dividend date. The ex-dividend date is the date on which you must be holding the stock in order to be entitled to the dividend.
The record date is the date on which the company tallies up who is due for dividend, while the payment date is the date on which the cheques are sent out (or, in the electronic age, the money is credited to your account).
Some companies announce profits and then announce an ex-dividend date in as little as three days time after the announcement. However, other companies will declare ex-dividend dates up to two months in advance.
In short, if the trader buys the share on or after the ex-div date, they are not entitled to the dividend payment.
For those in low tax environments, such as super funds and retirees, the company’s franking credits are also attractive, as no tax or very little tax is payable on franked dividend income, depending upon the individual’s marginal tax rate.
This makes dividends one of the best sources of income and is even more attractive for self managed super funds as even if they don’t pay tax, they are still entitled to a franking rebate.
How to do it
The share is bought before ex-dividend (ex-div) date, thereby collecting the dividend and associated franking credits, then selling the share after ex-div date with the aim of collecting a capital gain.
But for traders that are looking to take advantage of the franking credits, you will have to hold the stock for 45 days in order to be entitled to benefits.
Franking credits are essentially the tax that a company has already paid on its earnings. Because the company has already paid some tax, you don’t need to, and therefore you receive credit for the tax already paid.
The 45-day rule only applied to traders that earn more than $5000 worth of imputation credits. If you are not likely to receive more than $5000 worth of imputation credits, you can buy the stock the day before the ex-dividend date and sell it the next day if you like.
Free lunch? No
Dividends aren’t exactly free money: nothing is that easy. There are a number of pitfalls for careless traders.
In particular, be careful of stocks paying large, one-off dividends. This is because a lot of traders will tend to buy the stock for the dividend and sell it the next day. To best execute the strategy, look to strip companies that pay large regular dividends, such as the banks or Telstra.
Also, don’t leave it too late. Do your homework so you know when companies are likely to pay dividends. Most companies pay dividends at roughly the same time each year.
Most traders say that ideally the stock needs to be bought before the sudden price rise prior to going ex-div. In fact, earlier the better, really.
This is because many stocks actually rise strongly just before the dividend goes “ex”. For example, Commonwealth Bank gained 10% in the 10 trading days before its last ex-dividend date back in February.
In theory, after its ex-dividend day, the stock should fall by the amount of the dividend payment.
To get back to fair value, the stock can actually fall further than the dividend, resulting in a capital loss. And there’s the brokerage further adding to the loss.
A big move lower after a dividend is generally more the case with shares in downtrends rather than uptrends, so think about applying some technical analysis to the dividend stripping scheme.
So, it takes some fancy footwork and strong knowledge of the market to buy a stock, grab its dividend and franking credit and move on to the next one.
Of course, this strategy becomes more dangerous in more volatile or bearish market; especially a market such as the current one where the increasing levels of selling pressure means literally anything could happen.
Recent market action means that you might need to be more cautious with this strategy over this dividend season.