What are dividends and how do they work?

Dividends are a crucial part of investing, giving shareholders a share of a company’s profits. This guide explains what a dividend is, how dividends work, the different types available, and their impact on share trading. You’ll also learn about dividend rights, dividend trading strategies, and dividend futures as a trading instrument.

What is a dividend?

A dividend is a payment made by a company to its shareholders. It typically represents a portion of the company’s net earnings that are distributed rather than being reinvested in the business. The dividend amount and frequency are usually decided by the company’s board of directors.

A key reason why companies pay dividends is to reward shareholders, compensating them for their capital contribution and encouraging continued investment. Consistent dividend payments can signal a company’s financial stability, strong cash flow and confidence in its future earnings. This attracts more investors.

Dividend-paying stocks provide a means of passive income for long-term investors. They contribute to an investor’s total return, which includes both capital appreciation (due to share price increase) and dividend payments.

Dividend-paying stocks tend to be less volatile than non-dividend payers, offering stability to a share trading portfolio. Also, dividends can be reinvested to purchase more shares of the company, leading to compounding returns over time.

How do dividends work?

Important concepts associated with dividends include:

Declaration date

This is the date when the company officially announces the dividend payment. The announcement includes the dividend amount per share, the record date and the payment date.

Ex-dividend date (ex-date)

To be eligible for the dividend, an investor must own the stock before the ex-dividend date. If you buy the stock on or after the ex-dividend date, you will not receive the upcoming dividend. However, if you sell the stock on or after the ex-dividend date, you will still receive the already-announced dividend.

Record date

On the record date, the company identifies all shareholders registered on its books and, therefore, eligible to receive the dividend.

Payment date

This is the date of actual dividend payment to eligible shareholders.

Dividend payments tend to impact stock prices. When a stock goes ex-dividend, its price typically drops by an amount roughly equivalent to the dividend per share since the dividend value is now detached from the stock. Traders often monitor these dates closely to capture short-term trading opportunities.

Types of dividends

Dividends come in various forms, each with its own characteristics and implications for investors:

Cash dividends: these are the most common type of dividend, paid directly to shareholders.
Stock dividends: instead of cash, shareholders receive additional shares of the company’s stock. While this increases the number of shares you hold, it also dilutes the value of each share, so the overall value of your investment may not change immediately.
Special dividends: these are one-time, non-recurring payments, usually due to exceptional profits or a significant cash windfall (e.g. from an asset sale).
Interim vs. final dividends: interim dividends are paid during a company’s financial year, typically before the full annual results are released. Final dividends are declared after the full year’s results are released and represent the remaining portion of the year’s dividend distribution.

Cum dividend vs. ex-dividend

Understanding what is cum dividend and ex-dividend is vital for dividend trading. A stock trading ‘cum dividend’ means that the stock’s buyer is entitled to receive the upcoming dividend payment. The stock price reflects the value of this upcoming dividend.

On the other hand, as discussed above, on the ex-dividend date, the right to the upcoming dividend payment is separated from the stock. Anyone buying the stock on or after this date will not receive the dividend.

This impacts dividend investing strategies. Investors who want to receive the dividend buy the stock before the ex-dividend date. Similarly, selling on or after the ex-dividend date will preserve your rights to the upcoming dividend.

Looking to trade dividend stocks? Read our share trading guide.

Dividend rights and shareholder entitlements

Shareholders possess dividend rights, which entitle them to receive declared dividends. Some companies also offer dividend reinvestment plans (DRIPs). DRIPs allow shareholders to automatically reinvest their cash dividends into purchasing additional shares of the company, often at a discount or without brokerage fees.

Another related concept is rights issues. When a company needs to raise capital, it may issue ‘rights’ to existing shareholders, giving them the option to purchase additional shares at a discount.

Dividend stripping – strategy and tax implications

Dividend stripping is an investment strategy employed to benefit from tax laws related to dividends. It involves buying shares just before the ex-dividend date (cum dividend), receiving the dividend, and then selling the shares shortly after they go ex-dividend. The goal is to benefit from the dividend payment while potentially offsetting the capital loss from the share price drop or to take advantage of favourable tax treatment for dividends versus capital gains.

Many tax authorities have implemented rules to curb dividend stripping, since it can be perceived as a tax avoidance scheme. So, make sure you thoroughly understand the tax laws in your jurisdiction.

Dividend futures – trading dividends as a financial instrument

Beyond trading dividend stocks directly, you can also trade dividend futures. These are derivative instruments that allow traders to speculate on future dividend payments. They do not involve owning the actual shares. The value of a dividend futures contract is derived from the speculated total dividends paid over a specific timeframe. If the actual dividends exceed the speculation, the contract gains value, and vice versa.

Benefits of this dividend investment strategy include the ability to hedge dividend risk or speculate on dividend growth without owning the underlying shares. Risks involve volatility, leverage risk and the complexity of forecasting future dividends. This is why it’s crucial to learn about risk management.

Contracts for difference (CFDs) are a popular derivative instrument for share trading. Learn more about how to trade CFDs with Capital.com.

Trading dividend stocks – how to incorporate dividends in your portfolio

If you want to earn from dividend payouts, you need a long-term investment horizon. Shorter-term dividend trading strategies aim to capture price moves around dividend dates or execute strategies like dividend stripping.

Short-term strategies might include buying just before the ex-dividend date and selling afterwards. Alternately, you could simply focus on the stability and historical performance of dividend aristocrats (companies with a long history of increasing dividends).

Investing in dividend-paying vs. growth stocks is a classic dilemma. Dividend stocks offer income and often lower volatility, suitable for conservative investors. Growth stocks, on the other hand, reinvest most of their earnings into the business, aiming for significant capital appreciation but typically offering no or minimal dividends. This appeals to investors with a higher risk tolerance and longer-term horizon.

Learn more with Capital.com’s trading strategy guides. Open a demo account to practice these strategies.

FAQs

What are dividends?

Dividends are payments made by companies, providing shareholders with a share of the profits.

What is cum dividend?

A stock is cum dividend if it is trading with the right to receive the next declared dividend.

What are dividend futures?

These are financial contracts that allow traders to speculate on future dividend payments of a stock or index.

How do dividends affect share trading?

Dividend payments can influence stock prices, trading strategies and overall market sentiment, often leading to fluctuations in trading volumes around dividend dates.