With the expectation of tax changes next year some companies have been declaring eye popping special dividends, for example America Online (AOL) is giving out $5.15 and Costco (COST) $7. Intuitively it seems there should be some way to profit from these events, but as is always the case with Wall Street, there is never anything that approaches a free lunch.
At open on the ex-dividend day a stock will usually drop by about the dividend amount. Of course general market conditions will influence stock prices too—sometimes overwhelming dividend related moves. With AOL trading at around $37, the $5.15 dividend will amount to a 14% drop in the stock.
Three strategies come to mind to profit from this. None will work.
Sell the stock short right before the ex-dividend date.
- On ex-dividend day: You make money on the stock dropping, but since you borrowed the stock for the short sale you are now on the hook for the dividend. Unless the overall market drops, you will probably net out at a loss
Buy the stock and buy in the money puts on the stocks before it goes ex-dividend
- On ex-dividend day: Your stock drops in value, you collect the dividend, and your puts stay the same or lose money. Your puts will be adjusted by the option clearing house, either with a new strike price, or a cash payout you owe. Because of the premium decay and possible volatility drop in your options overall you will probably lose money. For more on option adjustment see this post. For news on specific adjustments visit the Options Clearing Corporation Website.
Buy the stock and sell deep in the money calls before the stock goes ex-dividend
- On ex-dividend day: Your stock drops in value, you collect the dividend, and your calls are adjusted to account for the special dividend. Your net result will be probably be a small loss after commissions.
Buy the stock a day or two before the ex-dividend date and hope for a pre-ex-dividend run-up
- Stocks will often rise in value right before the ex-dividend date. Certainly not anything close to a big special dividend, but perhaps worth your trouble. Have a target profit in mind. I use a limit order to close out the position.
Buy the stock before ex-dividend and bet that the stock won’t drop by the full dividend amount
- Oftentimes the stock won’t drop by the full dividend amount, or will bounce early in the morning after the initial drop. Figure out how much profit you would be willing to live with and set sell limit orders before open on the ex-dividend date.
Buy the stock before ex-dividend and bet that some investors will forget to cancel their open buy limit orders.
- In the case of a big special dividend there might be a lot of shares waiting to be picked off. To have any chance at selling into these orders you will need to be on-line at the beginning of pre-marketing trading and get your limit sell orders in. A normal limit sell order won’t become active until the regular market opens. Any juicy fruit available will already be picked off by the normal open.