Dividend Gap

Buying shares involves certain risks because their value might decrease. This could happen for various reasons, one of which may be a gap after the payout to the shareholders. The topic of today’s article is how to make money on a dividend gap and avoid mistakes.

Contents

What Does the Word "Dividends" Mean?

Successful companies make a profit from their activities. After all payments and taxes are deducted, companies can spend the remaining amount (the net profit) on business development or to pay remuneration to shareholders in the form of dividends. The portion of the net profit transferred to shareholders depends on the company. Some companies spend all their income on expanding production and do not pay any dividends. Others consistently transfer a high percentage of their revenue to shareholders, attracting new investors.

Who Decides on the Amount of Dividend Payouts?

It is the responsibility of the company's Board of Directors to determine the recommended amount of dividends paid out. The directors make a payouts proposal to shareholders, decide on payment dates, etc. The rules on making these decisions can be found in the document titled “the Dividend Policy”.

The Dividend Gap: a Simple Explanation

This term means a sharp drop in the value of the shares on the ex-dividend date — that is, on the day when it is no longer possible to receive dividends on the shares.

For instance, ABC company pays dividends and its ex-dividend date is July 10, 2021. So in order to receive dividends, you should buy shares before that day — on July 9 or earlier. If you buy shares on July 10, you will not receive the current dividends but will get the next. On July 10, the share price drops sharply by the amount of the dividends paid and the graph appears to tail off. If the payout was large (for example, with a dividend yield of 5%), then the share price will fall by about 5%. This event is called the dividend gap. It refers to the drop in share price that happens the day after the dividend payments.

What Causes the Dividend Gap?

After the information about the company's payouts to investors appears on the exchange, people hurry to buy up its shares. This usually happens after a decision is made by the Board of Directors. Investors rush to buy securities in order to get on the list of shareholders to receive dividends. The value of the assets grows due to the increased demand. There is a direct correlation between the amount of dividends and people's interest in these securities.

For example, at the start of 2021, nut producer John B. Sanfilippo & Son announced that it would pay out a dividend. Since then, its share price rose from $78 to $93, that is by 19 %! Contrast this to the average dividend yield in the US which is about 2% per year.

Experienced investors start buying shares long before the information about the dividend payouts becomes available. They are guided by the analysis of the company's financial statements, its dividend policy and the stability of payments. They achieve their goal once the shares are purchased and the investor is included in the company's register. Then, they want to receive additional income by selling the securities before the ex-dividend date.

How Do Dividend Gaps Close?

This happens after the share price returns to its initial level. The period during which stock prices rise after the restriction of the register of investors can range from a couple of days to tens of months. In some cases, the price of shares stays below the initial level and does not recover after the gap.

The rate at which the gap closes depends on several factors, such as how much share prices have fallen, the company's capabilities, the situation in the financial markets and political events.

Reducing the interest rates at which banks can borrow from the Central Bank leads to an increase in the money supply and, as a result, an increase in the demand for stocks.

It’s important to note that the main indicators for assessing the speed at which the gap closes are the company's dividend yield and the potential for its further growth. In this case, investors promptly buy up its assets, ensuring a higher price level.

In 2020, companies got rid of dividend gaps against the background of specific circumstances. The Covid-19 epidemic has led to a decline in many sectors of the economy. It is difficult to make forecasts for growth and dividend payouts in these conditions.

How to Get Dividends and Avoid Losing Money on the Gap

Most often, investors use the following methods:

  1. They purchase shares after the dividend gap for the long term. Their price will fall first, and then the investor will receive dividends that will make up for the loss from the short-term decline. In the near future, the price of securities will recover. The most important thing in this case is to choose the right company with promising shares.

  2. They buy assets as a long-term investment, receive dividends and recapitalize them by buying additional shares of this or another company.

Knowing how to get the due dividends and avoid the gap will help you avoid losses if you have free funds at the time of a sharp drop in the share price, or if you choose the shares correctly and the gap is short. However, unpredictable situations may also take place, such as securities failing to grow after a decline in their prices.

Strategies for Making Money on the Gap

Anyone who decides to invest in order to make a profit should think about setting up a straightforward system to achieve optimal benefits from transactions. They can select an effective algorithm from a number of strategies based on market analysis.

  1. The investor buys shares before the gap (before the ex-dividend date) and gets on the list to receive dividends. After the registry is closed, the price drops. The investor receives the dividends and does not sell the shares until their value rises to an acceptable level. The main advantage of this tactic is a guaranteed income. A dividend gap usually closes within a year, sometimes in a couple of weeks or even days. In the US, the dividend gaps are often small and the prices return to their original level in a few days.

  2. They buy shares on the ex-dividend date. At this point, their price is lower than on the previous day by the amount of interest paid. After the price returns to their previous level (before the dividend gap), the investor sells the shares.

  3. Another way to generate income is to buy securities immediately before the dividend gap. Then their price will increase and close the gap. The probability of prices increasing is very high. The yield will be good.

  4. The investor buys shares of companies with increased profitability. They should invest the dividends in the purchase of the same securities at a low cost during the gap period. These shares will make a profit after their price recovers.

What You Should Avoid Doing During the Gap Period

A stock exchange novice might attempt to make money on the situation when the share price rises before the closing of the register of shareholders and then falls sharply. But if you analyse the situation closely, you will find numerous pitfalls in doing so.

If you do not hold shares in a company, you can borrow them from a broker before the ex-dividend date and sell them at the maximum price. This operation is referred to as a short position or shorting the stock. After the share price declines during the dividend gap and the gap closes, you can buy cheaper securities and return them to the broker. It will enable you to make money on the difference in quotations.

How to Short the Stock Before the Dividend Payout

The following sequence of actions should be followed. The trader sells securities the day before the ex-dividend date. If they do not have any shares, they should borrow them from their broker. The day after the closing of the register, when the dividend gap occurs, they should buy shares at a reduced price.

To transfer the shares to the trader, the broker takes them from the client who purchased them earlier and is waiting for a dividend payout. The person who bought the shares on the last day when they were sold with interest should also receive the dividend payout. In this situation, the two owners of the same securities expect to receive dividends. Next, the trader buys the same number of shares that they borrowed from the broker, but at a cheaper price. They transfer the shares to the intermediary and they return them to the original owner.

The trader earns income on the difference in price that results from the dividend gap. Only information about the last buyer is entered in the register of shareholders. Why is the data of the original owner not included in the list? Because their shares were borrowed and sold. Only the last owner receives the dividends.

Be advised, the analysis shows that the selling of shares (or shorting) before the payment of dividends and subsequent repurchase during the gap period leads to minimal profits or financial losses.

Transactions with a Low Probability of Generating Income

A speculative trader buys shares right before the cutoff, gets on the list of shareholders, receives dividends and immediately sells the shares. They make money on dividends and sales if the drop in share prices is insignificant and does not last long.

Economists study the decline in share prices. Statistics show that the strategy described above does not work well. Trading on a dividend gap is risky and requires the scrupulous analysis of past data.

Please note that you should not expect that the share price will fall by an amount less than the amount of the dividend on the cut-off day. The likelihood of this happening is very low.

By buying the securities of successful companies with a dividend yield of 2-4 %, you can make money not only on dividends but also on transactions for the purchase and sale of shares before and after the cutoff. If novice investors know what a dividend gap is, they can avoid many mistakes.