Dividend Capture Strategy

What it is:

The dividend capture strategy is the act of purchasing a security for its dividend, capturing the dividend, and then selling the security to buy another about to pay a dividend. By doing this, investors can receive a steady stream of dividend income instead of waiting for an individual holding to pay its regular dividend.

How it works/Example:

To understand the dividend capture strategy, investors should be familiar with the ex-dividend date. In simple terms, it is the day new buyers of a security are no longer eligible to receive the upcoming dividend. Investors looking to capture a dividend must buy the security prior to the ex-dividend date to ensure they are a shareholder of record when the dividend is paid.

Investors using a dividend capture strategy will simply buy the stock prior to the ex-dividend date, ensure they will receive the payment by holding the security until the ex-dividend date, and then sell the security. In theory, they should be able to quickly buy and sell a number of securities near their ex-dividend dates and capture numerous dividends. However, in practice this is not always the case.

First, whenever a firm announces a dividend, often the share price will ramp up prior to the ex-dividend date to factor in the payment. Thus, investors buying after the dividend announcement and before the ex-dividend date often pay a higher price for the security.

Once the stock "goes ex-dividend," the price usually falls to reflect the value of the dividend payment since after the ex-dividend date, buyers of the stock or fund will not receive the upcoming dividend. These actions result in a higher buy price and a lower sell price in many circumstances.

Another component of the dividend capture strategy is taxes. Dividends paid on securities held for less than 61 days are subject to taxation at the investor's regular income tax rate. Therefore, someone who buys a stock the day before the ex-dividend date and then sells in two days later will be subject to a tax rate of up to 35% (depending on the investor's tax bracket) instead of 15% if they held the stock for 61 days.

The dividend capture strategy is still popular with investors looking for dividends taxed at the 15% rate as it allows them to gain more payments per year than just holding on to one security. By employing this strategy, investors can capture more dividends in any given year from the same investment dollars. Let's say an investor purchases a stock that pays quarterly dividends (most companies pay on a quarterly basis). In this case, the investor would receive four dividend payments throughout the year. However, if that same investor uses a dividend capture strategy, then he or she would not hold the stock for a full year. Instead, the investor would purchase the stock before its ex-dividend date and would sell it 61 days later. After the sale, he or she would then turn around and plow that money back into another company that is about to pay a sizable dividend payment.

If you assume a 61-day holding period for each captured dividend, this investor would be able to pocket six dividend payments during the year (365 days divided by 61 equals 6) instead of the traditional four -- that's 50% more dividends from the same investment dollars.

Many investors and mutual funds produce attractive returns with this strategy, but it does involve higher trading costs and the risk that share prices will not bounce back after a stock goes ex-dividend.

Why it Matters:

Using a dividend capture strategy is one way investors can boost their returns from the markets. While it does involve higher risk and trading costs than a simple buy-and-hold strategy, investors looking for a way to create a steady stream of dividend income may find the strategy attractive. Likewise, those looking for tax-advantage dividends may like that they can earn more dividend income in a year than under normal circumstances.

The expiration of the Bush tax cuts (after 2010) may have a major impact on this income strategy. Unless the U.S. Congress extends the tax cuts, dividends will be taxed at the investor's normal tax rate, regardless of how many days they hold the shares.

[InvestingAnswers Feature: Capture 50% More Dividend Payments With This Simple Strategy]

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