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, 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.
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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. 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.
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. 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.
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.
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.
