Is it possible to make trading profits with dividends? Normally, dividends tend to be largely value neutral for investors. Dividend is paid out of profits and to that it is seen as partial liquidation of net worth. What the investor gains as dividend, they normally tend to lose in terms of value. But then dividends are not just about the actual dividend declaration but also about the expectations. That makes a major difference. There are 4 ways in which you can make the best of dividend announcements.
Betting on better than average dividends
Valuations are not determined by the actual dividend declared but by the actual dividend vis-à-vis expected dividends. For example, if a company has typically paid out 40% of par value as dividends and this year it increases its dividend payout to 50%, that is positive for the price. That is where the actual dividends versus the anticipated dividends make a difference to the price. Cash market traders can position themselves long on stocks where the dividend payout is expected to go up as this is considered to be price accretive.
Betting on bottoming of dividend yields
Dividend yield is defined as the dividend paid as percentage of the stock price. For example if a share quoting at Rs.100 and it pays Rs.5 as dividend, then the dividend yield is 5%. Historically, stocks tend to bottom out at around 4-5% dividend yield except in case of extremely cyclical sectors. In such cases, traders can position themselves to trade long when the dividend yield touches this range. This is an indicator that normally works to perfection since sustainable dividend is the best hedge against price fall.
Using dividends for arbitrage
This is a slightly more interesting way of playing the dividends. Let us first focus on what is arbitrage; of course we are referring to cash futures arbitrage. In this case, you buy in the cash market and sell equivalent quantity in futures. That means trades will have to happen in lot sizes or multiples thereof. Futures are at a premium to the spot and this profit can be locked in because on the F&O expiry day, they will expire at the same price. How do dividends fit in here?
The holder of the cash market position earns dividends so the arbitrage spread will automatically adjust for dividends. If you are anticipating higher dividends on a stock then you can create arbitrage at a much lower spread and much more easily in the market since you expect the dividends to compensate for the lower spreads. This is a window of opportunity that traders can use to create arbitrage positions before the market moves in and prices the spread away.
Using dividends for futures trading
Remember that dividends are not paid on futures but only on cash market holdings. However, future prices do get affected because when spot prices fall, the futures fall too. For traders there is an important thing to remember about dividends and when to trade for dividends on futures and options. Let us look at two different scenarios.
- When the dividend declared by a company is less than 10% of the price of the stock, then it is classified as ordinary dividends. In such cases, the exchange does not make any adjustment and the market makes the adjustment to the price. In such cases, you can look to trade price movements as a result of dividends.
- However, such a move can backfire if you try trade in case of extraordinary dividends. When the dividend paid is more than 10% of the price of the stock, it is classified as extraordinary dividends. This includes special dividends declared from time to time also. In the case of extraordinary dividends, the adjustment is made by the exchange and the strike price of options is reduced accordingly, one needs to structure trades appropriately.
The moral of the story is that dividends do offer an opportunity to structure specific trades for your unique needs. The ball is entirely in the court of the trader.