It's profit and dividend season. This Dividend Pairs Trading strategy is something I've developed over the last 2 reporting seasons
The premise of the strategy is simple. I do a lot of pairs trading, and I noticed that, whenever I hold a short position in a stock going ex-dividend, I am almost always worst off on the following day. Furthermore, the fall in a company's share price on he ex-date is often less than the full amount of the dividend, and the franking credits are usually "free".
Now there are plenty of dividend drop-off/stripping strategies around, but in the current market environment a lot can happen overnight and I for one am not comfortable with holding large naked long positions just to pocket the dividends. So this strategy basically combine the dividend stripping approach with a hedge using a similar company to make it somewhat "delta neutral".
So to execute this strategy...
1. Find a share that's going ex-dividend tomorrow. Preferably you want to look for a company that just had a good profit report, a high dividend yield, high % franking and a share price that hasn't run too hard. This will be the long leg and is opened the day before it going ex-dividend.
2. Find a company to hedge. Preferably, this company should be in the same industry/sector as your long leg, not be going ex-dividend or reporting anytime soon, displaying weak share price strength or a topping pattern, and definitely shouldn't be a takeover candidate. This short leg is opened on the same day as the long leg.
3. Close both legs the following day or two.
Profit margins are slim (~average 1-2%) and are highly dependent on the trader's skill in making the entry/exit and the trader's knowledge of the companies used for both legs of the trade.
A few more things to consider...
- Both legs should also have good liquidity to allow easy entry/exit.
- Since the profit margins are small, you need to use a low cost broker so the effect of commission is minimised.
- Franking credits will be a large part of the strategy, but since the holding period is <45 days, you might only be able to use this strategy for <$5k worth of FC... and once you go over you lose all FC that you didn't hold over 45 days.
I will write a brief journal over the next 2 months and see how it goes. I will stop once the franking credit accumulated = $5k.