Ask Colin

How do you react to stocks going through your stop when they go ex-dividend?

The detailed question was:

I’d like to know your thoughts on when a stock going ex-dividend causes a share price drop through a sell stop. If a closing price is above a sell stop by less than the dividend amount the day before going ex-dividend, does that affect you (presuming the price will drop by the dividend amount the next day and through your stop)?

Or do you ignore that and see where it closes on the ex-dividend day? I realise that for lightly traded stocks you would probably wait and see, but what about heavily traded ones?

I have already addressed this in Ask Colin under Stops – When a stock goes ex-dividend do you adjust your stop-loss?

All I would add to that is that your approach to the problem will depend on whether you are a trader or an investor.

For a trader – you are trying to make capital gains by buying and selling at a higher price. Stops are to protect capital and by falling through your stop, your capital is at risk. That said, you have gained a dividend and maybe franking credits, so it is very arguable that a trader might want to adjust the purchase price accordingly, or maybe better still, to adjust the chart for the dividend which will automatically adjust the stop.

For an investor – the mindset is totally different. You are buying part ownership of a business and that means you are seeking an income stream. Over time dividends and franking credits will greatly outweigh capital gains – the longer you are an owner the greater the proportion of your return that will be from reinvesting dividends (in that stock or in your portfolio). If you owned the whole business it would not be traded on the market and there would be no market price that would change for all kinds of reasons, including when you took out some dividends. So, you would assess whether you might try to sell your business only based on the rate of return from the business. This is what you should also be doing when you buy a part ownership in a listed business. You buy and sell based on the performance of the business, not the market price. The most colourful explanation is Ben Graham’s famous Mr Market (Google it). Investors would not adjust their purchase price or their chart for the dividend. However, see the earlier answer on that point with respect to capital returns in the form of dividends.

That said, the reason why an investor has stops is to protect capital. Investment stops will be far wider than trading stops. This means that when stock go ex-dividend, the price will not generally fall anywhere near their stops making the question irrelevant. However, there are two situations where a stock going ex-dividend might trigger a stop:

  1. If the business is not performing well and the market price is falling. Sometimes companies will pay a dividend or even pay an increased dividend to try to hold up their stock price. This generally does not fool  the market. So, in such a situation, you need to analyse the business performance of the company and decide if the market has it right. If Mr Market has it right, you should probably have already sold anyway. If Mr Market has it wrong, it is a buying opportunity to be assessed.

  2. If you are an investor, but have your stops way too close, such as a short-term trader would have. In that case you are unclear about what you are doing. Ask are you really an investor or a trader and the answer should be there for you.   

Keyword: