My recent missive on dividends prompted a couple questions I wish to address in today’s post. The first comes from Dan, whom I shall hereafter refer to as “Dan the Man” because I like how it sounds. The question referenced how stock prices react when a dividend is paid out. Specifically, that stock prices fall by the amount of the dividend.
The short answer is yes, Dan the Man, stock prices are indeed adjusted when dividends are paid out. The reason is encapsulated in an oh-so-short acronym: TANSTAAFL.
There Ain’t No Such Thing As A Free Lunch
Such a phrase is often quoted by Economic professors vigorously preaching to their pupils that you simply can’t get something for nothing. And nowhere is that more true than on Wall Street where everything has a price.
To wit: some rookie traders looking to game the system around dividends might dream up the following. “Why not just buy a stock right before a dividend payout, then sell it immediately after thereby capturing the dividend with virtually no risk? If AAPL is trading for $100 and pays a $1 dividend to holders of the stock on record at the end of day today, why, I’ll simply buy a few shares at 3:59 PM EST right before the bell and unload them tomorrow morning right at the open. Such a gambit will allow me to effectively score a 1% return on my money overnight with little to no risk. Eureka! A sure thing if there ever was one. Thank you momma for making me sooo smart.”
The day arrives, you load the boat with AAPL shares for $100 at the close and sleep soundly that night with dreams of risk-free profits dancing in your head. The next morning you dutifully go to unload your shares and to your dismay the stock opens at $99. Oh the Horror!
Your $1 dividend was offset by a $1 drop in the stock. Curse you TANSTAAFL!
But wait, if the stock is going to drop by $1 then why not short the crap out of it the day before? Then swoop in to snatch it back the next morning at its now reduced price. I smell an opportunity!
Or not.
TANSTAAFL strikes again.
When you short a stock you have to pay any dividends doled out by the company. So, your $1 gain in the short position would be offset by the $1 dividend you have to pay out for being short the stock.
Bottom line: there’s no way to score free money on a dividend in the short run. But that doesn’t mean dividends don’t make investors money in the long run. Think of it. If a stock that paid a dividend always dropped by the payout amount wouldn’t it eventually hit zero? It would. But it doesn’t. Because investors eventually bid the thing right back up again.
In the long run it’s tough to spot when dividends were paid out. Take a look at SPY. It’s been paying dividends since inception. But can you see it on a 10-year chart? Nope. Price adjustments for dividends don’t even register on the Sir SPY’s path to world domination.
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5 Replies to “Tales of a Technician: Of Dividends and Free Lunches”
Excellent explanation, great graphic–did you draw that, Tyler? YGMS (You got many/mad skills)
But of course my good man. And did you just make that acronym up? Do the cool kids use that these days? I shall add it to my repertoire.
Well said my friend… well said.
Yes, I have been called Dan the Man many times. Great answer. But what about short puts about to expire? Should this be avoided around dividend time?
Dividends are already priced into options so no, you don’t have to alter your management of short puts around dividends.
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