Dividend Capture

Here are my philosophical underpinnings of dividend-capture trading.

The challenge is the perceived "normal" behavior of stocks: Theoretically, they are supposed to drop by the dividend amount on the ex-dividend date. It turns out this is far from normal, and most stocks will trade back to their pre-dividend price in a short period of time.

This observation is why dividend capture can work, if executed effectively. If dividend payers were efficiently priced, they would drop by the amount of the dividend on the ex-date, then spend three months (or at least some very long time period) working their way back to the pre-dividend price. Reality is far different, fortunately. I researched the behavior of dividend-paying stocks and discovered that the majority went back to their pre-dividend price within two weeks of the ex-date. Even in the 2000-2002 bear market, 60% to 70% of stocks bounced back within a couple weeks.

Keep in mind that the two-week period was chosen arbitrarily. Extending it to one month enables even more stocks to bounce back. The challenge in dividend-capture trading is to avoid the one-third of stocks that do not bounce back. Of course, over time you will always be caught with a few of these. The successful dividend-capture trader will minimize both the bad picks and the magnitude of losses when a pick does go bad. Obviously, this is no different from one's efforts in regular capital gain trading.

I usually give myself a couple of weeks to a month to get back to even. I typically don't buy very close to the ex-date. Dividend stocks often spike right into the dividend, as Bristol-Myers did on September 28, for example.

Hazards on the Course

Part of understanding the strategy is to study dividends to avoid. One to possibly avoid last week was NLY. Despite (or because of?) a gigantic dividend of nearly 4%, I passed on this one. There is still substantial risk in the mortgage space, and the high yield indicates that the market does not believe in the sustainability of the dividend. The trade very well might work, but I simply don't want to take the risk. Generally, I target stocks in which the dividend payment is between 0.75% and 1.5%. More on the rationale for this range in the future.