Accredited Investing Education

Dividends – How do they work?

What is a dividend

A dividend is a cash distribution of a portion of a company’s profits to the shareholders. The board of directors decides if a dividend will be paid, when it will be paid and how large of a payment will be made. Dividends are typically paid on a quarterly basis. Some companies will issue special one-time dividends.

How do you collect the dividend

To collect the dividend you have to be the holder of record on the date that is called the “date of record”. To be the owner of record, you must own the stock at least three days before the “date of record”. That allows the company time to record the change of ownership. The day two days before the “date of record” is called the “ex-dividend date”. This is the date that the stock begins to trade without the dividend. You will still get the dividend if you sell the stock on ex-dividend date. The dividend will be paid on the “date of payment”. It may be important to note that there are tax considerations around how long you own the stock before and after the dividend. Consult your tax advisor for more information.

The key date here is the ex-dividend date. Own the stock before and after that date and you will get the dividend. Stocks that pay a large dividend will often have prices that move around the ex-dividend dates in a very predictable pattern. Knowing how to trade that pattern with options can be far more profitable than owning the stock.

How it can be traded

You can certainly buy a stock or a basket of stocks that pay dividends and collect the dividends. Hold the stock long enough and you get a dividend that may be at a lower tax rate. Understand the price patterns, how a stock moves, and you can not only collect the dividend but you can also buy and sell the stock to also collect capital appreciation. Typically the best time to buy a dividend paying stock is shortly after the ex-dividend date.

Stocks that pay a significant dividend typically drop on the ex-dividend date by the amount of the dividend and a little more. That can be a great time to purchase the stock. Study the charts for the past few years and see how it moves, typically the best time to buy will be during the summer and a couple of days after the ex-dividend date. Sell in May often means that June is a great time to buy.

The problem with owning stocks is that you can’t spend capital appreciation unless you sell. You can spend the dividend once it is paid. Add options to the mix and you can greatly enhance your income with or without buying and selling the stock. It is helpful to understand that options on dividend paying stocks “act” a little different.

Some or all the extrinsic value of the ATM and ITM calls will “disappear” the day before the ex-dividend date on some stocks and then comes back on ex-dividend. This keeps short calls from being very profitable. The extrinsic value on puts will increase before the ex-dividend and come out on ex-dividend. This keeps long puts from being very profitable even though the stock drops on ex-dividend. Data shows that extrinsic value can be used to determine the likelihood of being assigned early. On dividend paying stocks that likelihood goes way up on the day before ex-dividend. So how can you make money with options on dividend stocks?

There are several trades that have proven very effective on stocks with patterns like some high dividend paying stocks. Well timed and placed bull puts can result in returns far greater than buy and hold. You can choose the risk/reward and probability that fits your goals and style. String together a bunch of dividend paying stocks that have ex-dividend dates in different months and you can have a trading plan with monthly income.

Ken Bailey
OptionsANIMAL Instructor