Dividend Capture Options Trade Step By Step How I Trade Stocks For Fast Dividends

As first read in Rocco Pendola / Robert Weinstein option newsletter...

How To Capture Stock Dividends?

The easiest way to capture a dividend is to simply buy the stock and hold on to it. As long as the company continues to declare dividends you keep receiving the payments. Of course, this is not usually what traders have in mind when they start out capturing dividends. Even so, many traders/short-term investors start out with a plan to own a company for a very short period of time, capture the dividend, and dump off the shares quickly. What happens is the stock doesn't trade high enough after the dividend is captured to get out at "even" and traders end up becoming investors. 

Don't get caught in the "newbie" trap of believing it is important to break even on losing trades. Professionals give very little, if any, thought to the breakeven point on any given trade. If you want to move past the beginner level you have to let go of the grip "breakeven" has on so many people. Enough about the trading discipline (I have many articles written on that subject), let's move on beyond long-term dividend buy and holds and move on to something with potential for greater returns.

The Trap

After buy-and-hold, many new traders quickly get that "bright idea" (I did the same) that they can buy the stock the day before it trades ex-dividend and sell the day of ex-dividend and make truck loads of cash. The idea of buying a stock before it trades ex-dividend (the day before for example) and selling it the next day has likely been around for about as long as the stock dividend has been around. It may be slightly debatable if there is a real edge or not (likely there is), but the transaction costs and the incredibly small edge if there is one make this idea dead on arrival. Stocks tend to trade (at least during pre-market and or normal opening) about the same price as they did into the previous closing less the declared dividend amount to be paid. As such, there has to be a better mouse trap built to catch this one. Fortunately there is, but like many things in life, it takes work and dedication to learn and master it.

A complete review of what a dividend is with key terms (Paid2Trade)

We can use options to partially hedge our position in order to gain the dividend. Quickly, you will see that capturing dividends is as much about capturing option premium as it is anything else.

When I first explored the idea of dividend capturing I read a lot on the subject and dove in the deep end with both feet. I quickly learned many of the pitfalls and ways to lose money by not fully understanding everything there is to know. Stepping on landmines is not fully unique to investing for me, but that is another story altogether. 

The best words of advice I can give to those starting out in dividend capturing is to use a "paper trading account" or a "simulated trading account" to learn the ins and outs of execution. One thing paper trading will not likely give you is the experience of having your shares called away, so clearly there are limitations to how "real" it can be. Even so, paper trading new ideas makes sense. Professionals often paper trade. Just about any job that requires skill, where you put something on the line, has participants "simulating" the event first. We would not want pilots, doctors or lawyers practicing their jobs on us after only reading about what they are about to do. You should demand the same from your money manager (likely YOU). Here is an article on paper trading and why you should do it.

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If you have spent any amount of time reading about stock dividend capturing you likely run into a lot of the same material, but perhaps written differently. It goes something like this "Buy XYZ for $50, Then sell a deep-in-the-money call (the deeper the better), like a call with a $20 strike price to hedge with. Wait until after the stock trades ex-dividend, buy back the option and sell the stock and move on to the next one."

The Problem With Typical Dividend Capture Strategy

First, there is usually not going to be a super deep-in-the-money call available to buy. Even if you do find one, there is usually no one wanting to buy one from you (unless it's the market maker which we will talk about soon) and the reverse is true when you want to buy it back. Of course "someone" will buy any traded option at any time options are traded, but the problem with that is the all-important factor called  price.  

Options are not a true market like stocks and futures. Only market makers can "make a market" in options. These rules are like licenses to steal, issued to the market making trading firms of the various option exchanges. They are like licenses to steal because they keep the volume lower, spreads wider, and profits larger for the market makers at the expense of other market participants. Trading options today is much like it was trading stocks 20 years ago. Back then, as a retail trader you could only buy at the offer and sell at the bid paying the spread every time. It's not near as bad as that now with options because you are able to make a bid or an offer on the market, but you are not able to do both at the same time. If anyone could bid and offer at the same time the spreads would be smaller and the trading would increase because there would be more opportunity. What is really important to know if that you generally do not want to transact with a market maker because they will only transact when they are buying at a price that is lower than the true value or selling at a price that is higher than the true value. That is how market makers make their money, by providing "a market."

Because we are able to post offers and bids (at least with the right brokers anyway, not all allow this and you should question why you are doing business with one that doesn't) we are able to, theoretically, trade an option hedge on a stock we want to capture a dividend with. When you execute a dividend capture, you must ensure you sell the stock option hedge for enough premium over intrinsic value so that if you get your stock called away before it trades ex-dividend you will still make enough to justify putting the trade on. 

Learn About Intrinsic Value In Options Here

Stock options tend to get exercised most on option expiration day because there is little or no time premium left. Other than option expiration day, the day before a stock trades ex-dividend is the day options most often get exercised. The reason in mathematical terms is beyond the scope of this article, but can simply be summed up by saying it is more advantageous for the option owner (person who bought the option from you) to exercise and collect the dividend than it is to continue holding the option that is about to go down in value by an amount equal to the dividend amount. Therefore, the amount of premium collected cannot just be any amount over intrinsic value but enough to justify the risk. 

I use a mathematical formula to calculate what I believe the minimum amount is. I use this formula in my own trading and for the dividend capture articles I write. The variables that go into the mix include historical volatility, the amount of the stock dividend, the current yearly dividend yield, the expected time to hold, the expected amount difference point for the stock option owner to exercise before ex-dividend, the volume of the stock, the volume and open interest of the options, the amount of intrinsic value (how much of a hedge are we getting) as well as some smaller variables.

Because I am not looking for an option to sell that is deep in the money (I am willing to, I just almost never see an opportunity to do so) what am I looking for? 

I am looking for an option that is IN the money but does not have to be nearly as deep as some others suggest. Obviously this raises the level of risk. To be sure, this is not a riskless trading idea. Over time with enough trials (lots of dividends being captured) I believe there is a mathematical edge, but there are no guarantees. In another way that may be easier to understand, if you count cards at a blackjack table in Las Vegas, you may be able to have the odds put in your favor because you will know when to bet big and when to bet small. If the house didn't care who counted cards you could simply not bet during times the house had an edge, and bet only when you have the edge. The best thing about Wall Street in general is the ability to wait and not bet until the odds are in your favor. Having the odds in your favor doesn't mean winning all the time or winning on any give trade. What it means is that over time, with lots of transactions, you SHOULD be able to make money, just like our card counting friend. This type of math is what casinos are built from and while they may take a loss that is big compared to most of the wins they receive from all the gambling tourists, they know as long as the odds are in their favor they win in the long run.

In order to put the odds from the house's (market makers) favor into my favor, I need to partially act like the house. When I find the best call option to use as a hedge, I find the minimum amount I need to sell the option for. IF the current offer price is at or above the amount I need to sell it for I enter an order to sell the call option for at least the amount needed above intrinsic value. If the options have huge amounts of volume this may even be the same as the bid amount. Usually it's not and I run into the next problem facing option writers.

As the stock moves up and down, the relative "cheapness" or "expensiveness" of your offering price changes. If the price of the stock moves higher and you do not change your offering price, you are selling the option for a value that is cheaper relative to the price of the stock. At some point you WILL sell the call option, but at a price that may likely be too cheap to make a profit from. If the stock price moves lower the other offering prices will move lower (market makers use computers to automatically adjust their pricing) and you will not sell your option hedge. If you have already bought the stock you are now taking an un-hedged risk. Not a good idea for this strategy.

You could manually keep adjusting the price higher and lower throughout the day, but that can get boring quickly. Plus you likely are not going to be fast enough to change it every time the stock really moves and it just ends up a losing deal. On top of the previous good news about manually adjusting the price is the cancellation fees. The exchanges charge every time you change or cancel your limit option price.

What Can You Do Then?

Some brokers allow automated order entries that do permit fee-free changes to the limit price placed. Interactive Brokers (IB) does. I use them. I highly suggest looking for others before deciding to open an IB account. IB is not the broker you want if you need any type of instruction or hand holding. IB offers almost zero customer support and are known for having very poor customer service on phone or chat.

So I enter into my trading platform the amount I want to receive for the option hedge (at and often above the minimum I need to make the trade worthwhile) and the amount it should move in relation to the movement of the stock and wait and see. If the options have a fair amount of volume and the dividend is not too large of a pricing factor (if the ex-dividend date is far enough away and the amount of the dividend is relatively small) I generally get filled the first day and within the first hour (I normally like to put the trade on during the first minute of the trading day as that is also the busiest time of day for options)

Upon getting some or all of the calls sold at or above the price I need to receive I like to immediately buy the stock portion of the trade. This leaves me with exposure to