There are a number of trading strategies CFD traders can use over dividend periods and one of these strategies is referred to as dividend stripping. Dividends stripping revolves around buying shares prior to the dividend being paid and selling those shares just after that payment.
The idea of trading for dividends is not by any means new. If an enterprise pays a yearly dividend of, say, 7 per cent they will usually make two payments of approximately 3.5% per dividend. This is not really a huge return on investment but what if you could use leverage to gear your position up to 15 times using CFDs? The return now soars to 52.5% on the margin money utilised.
This sounds much more attractive, huh? But this theory has one flaw; granted you will stand to receive a 52.5% return in cash on dividend paying day but in reality the share will drop by the amount of the dividend on the ex-dividend date, losing 52.5% of the margin requirement for a zero end return. But wait, all is not lost yet.
The great thing about contracts for difference is that many of the strategies that have been developed over the years for share trading can be used with CFDs, and cost a lot less because of the leveraging of your money. One of these strategies is known in the hedge fund industry as dividend stripping or dividend play, and in some cases using CFDs can make all the difference between a marginal profit and a gain worth making.
Active share traders have traditionally done dividend stripping by buying the equities. The way it works is that the trader buys the shares before they go 'ex-dividend'. When the shares go ex-dividend, the shareholders no longer qualify to get the dividend, which is usually issued a few weeks later so a company's share price will usually fall to account for the cash bound for investor's pockets (and leaving the balance sheet). Now when a company issues a dividend, there are several expected actions.
First, shares often rally in anticipation of the dividend to be issued, so in the last couple of weeks before the announcement, the price will rise. This is because of buying interest from investors wanting to hold the shares on the ex-dividend date and thus qualify for the payment. After the date, when the companys shares are trading ex-dividend, in theory the share price drops back by the amount of the dividend. This drop happens because a dividend payout automatically reduces the value of the company and the investor would have to absorb that reduction in value as neither the buyer nor the seller are eligible for the dividend. In practice, particularly with quality companies, the price does not drop by the whole amount of the declared dividend - stocks with good momentum often don't fall by the full amount. Thus a trader could buy the shares via a CFD, banking the dividend and get out just before the share price has fully settled down often translating into a profit in the process.
An alternative trading strategy is to buy before the ex-dividend date and sell either the day before or on the date to take advantage of the run-up before the dividend payment. Even another strategy revolves around buying the stock on the ex-dividend date and selling it a few days later to pick up the recovery after the drop.
Of course the ex-dividend effect is obviously only one of the dozen or more factors that typically influence a share price. It doesn't by itself dictate that the share price will necessarily drop by an amount equivalent to the value of the dividend. If it happens to be a day when no other stock/sector/market factors are in play, it can do just that. Other factors might outweigh it - but within that mix of factors, going XD will be a negative one. And if the outlook for that particular stock is a bit iffy or markets are negative, and holders were only staying onboard to qualify for the divi before leaving, XD day sales can sometimes be the catalyst that kicks off a downward slide. If the dividend is only a tiny one it might have almost no noticeable effect at all.
Naturally, the best time to take advantage of a dividend trading strategy is during a bullish market as this allows you to buy and hold a contract for difference for a number of months including the dividend paying periods, potentially offering you the benefit of a capital gain plus an income stream via the dividends. This trading strategy works better in a bullish market because the dividend effect is typically not strong enough to overcome rapidly falling share prices in a bearish market. Couple this with the fact that you are leveraging your holdings using CFDs and you can being to appreciate how substantial gains can be made using this strategy.
Like traditional shares, contracts for difference have the added benefit of dividend income (90% of gross dividend) on 'long' positions (do check this with your provider or broker as different providers may have different policies regarding dividends). This is calculated on the close of business the day before the stock's ex-dividend date. After the 10 per cent dividend tax has been deducted, you would expect to get about 90% of the gross dividend. Note that if you hold a 'short' position this will work in reverse as you will then be liable to pay an amount matching the dividend payment. The ex-dividend date was created to allow all outstanding deals to be finalised before the record date. If an investor does not own the share before the ex-dividend date, he or she will be ineligible for the dividend payout. Most stock broker firms will pay out the dividend in a timely manner, mostly within a week although theoretically they could leave it until the payable date which could be as much as a couple of months. A CFD mirrors the underlying share with the additional benefit of instant settlement as the dividend payment is usually immediately settled as soon as the stock goes ex-dividend.
Understanding dividends and ways to trade contracts for differences around dividend periods is vital when developing your CFD trading plan. There are a couple of ways that dividend stripping is implemented, and these can be done with the advantage of leverage by trading in contracts for difference, which will allow you to capture the price gains without finding the full share purchase price. One way is to trade the shares on the day before they go ex-dividend, and sell them immediately afterwards. If the price does not drop by the whole amount of the dividend, as frequently happens, then the trader stands to gain perhaps 0.5% by this strategy. Using CFDs with the built-in leverage allows you to gain perhaps 5% instead (not bad for a couple of days trading!), which makes the risk much more worthwhile. The interest charged for the CFDs will be minimal, as you do not intend to hold them for long but dealing costs (entry/exit commission fees) will still be key. So, if you buy a contract for difference then instead of buying £10,000 shares you can buy exposure for £100,000 and get ten times the return.
Another way to implement dividend stripping, which is slightly longer term, is to buy the shares, or in this case buy the CFDs on margin, a few weeks before the dividend is declared and the stock goes ex-dividend. You then have a choice of selling before the ex-dividend date, profiting from the run up which should raise the share price, or including the strategy above, where you collect the dividend and expect that the share price will not fall by the full amount (this is especially tru during bullish markets).
As an actual example, consider the Commonwealth Bank of Australia three years ago. The stock was trading on the 5th February 2007 at $50.40. A dividend of $1.07 was declared, which would go ex on the 19th February. In the run up, the stock traded up to $51.81, and on 21st February, after going ex, the stock was at $50.51. Buying on the 5th February, you could have made $1.41 per share by selling before the ex date, or $1.18 by taking the dividend and selling a few days later. With the leverage of a CFD, that would mean that for a margin of about $5 you would receive well over $1 in return.
EDIT: 'Dividend fishing' isn't an easy game. That isn't to say it cannot be done. There are traders who weigh what they perceive to be the likely factors in play on ex-dividend for a particular stock. If they can see that factors other than the XD-effect are going to bump up the share price regardless, they might choose to go fishing, capture the dividend, bank a profit on the trade, and might consider that a win-win transaction. But arguably the trade win is smaller than it would have been without the ex-dividend factor (ie the share price rise would have been higher by the amount collected as dividend), so there is perhaps no real gain in doing it that way. But it shifts part of their gains into income rather than capital gain, so I guess there are ways in which that might be advantageous to some players.
So the tax implications of dividend income should also be considered. Contracts for Differences are subject to (CGT) capital gains tax at 28% in the United Kingdom, however dividends are only taxed at 10%. Thus, if you are believe that you likely to exceed your annual personal CGT allowance of £10k, this potentially opens up a way to reduce your tax liabilities. Whichever perspective you see it there are definitely opportunities around dividend time for both traders and investors and although dividend income is naturally more appealing to long-term investors, the speculative trader would do well to not ignore it either as dividends can still play a role in the CFD trader's strategy.
Note: The ex-dividend date is the first day on which it is no longer possible to buy the shares and qualify for the dividend. The record date is usually two days after the ex-date. The payment day is the day on which funds are transferred to shareholders. In practice the only date you need to worry about is the ex dividend date, which is usually a Wednesday - if you want the dividend, make sure to be in by close of play on the Tuesday or the day before, the stock will then go ex-dividend the following day normally suffering a price adjustment to allow for the dividend being paid some time later normally about 6 weeks I believe on the Payment Date. You do not need to be holding the shares on the Payment date to qualify, just have them on ex-dividend day.
The content of this site is copyright 2011 Contracts for Difference Ltd. Please contact us if you wish to reproduce any of it