Photo: Freeimages.com/Paula Navarro

We all invest in dividend growth stocks in the hope that they’ll increase in value. And over the long-term that’s usually how it works out, especially with solid dividend growth companies. But what do you do when a stock you’re interested in looks like it’s headed downwards? Some investors look at that as an opportunity to use a technique designed to profit from a drop in stock price.

Known as “shorting” a stock, it refers to borrowing a stock from someone who owns it and then selling it. You don’t know who you’re borrowing it from – it’s generally done through a brokerage and the stock exchanges keep track of who’s borrowing which stock from whom. When you sell the stock, you collect the proceeds. Later on, you can buy the stock back and then close the “loan”. If the price of the stock dropped while you were short, you paid less to buy it back than you got for selling it. That difference – between the price you received when you sold it and the price you paid when you bought it back – is your profit.

Sounds easy, right? Not so much.

There are several risks involved with shorting stocks. First, this is a technique best used over a short period of time and not for long-term holdings. Second, and most importantly for investors in dividend stocks, is the dividend itself. When you hold a dividend stock through its ex-dividend date, you’re entitled to the dividend payment. Conversely, when you borrow a dividend stock through the ex-dividend date, you owe the dividend to the person from whom you borrowed the stock. The reason for this is that the dividend is paid to the new owner of the stock (the person who you sold the stock to), but the person you borrowed the stock from still owns it and is still owed the dividend as well. (This is also why you can’t benefit from shorting the stock through the ex-dividend date. The stock price drops by the amount of the dividend, but the gain you receive by the drop in price is lost because you have to pay the dividend to the person who you borrowed the stock from.) This cost tends to erase any benefit from shorting the stock.

Another way to profit from drops in a stock’s price is through the use of put options. Buying a put option gives you the right, but not the obligation, to sell a stock at a particular price and tend to increase in value when a stock drops in price. However, the price of a put option isn’t only related to the price of the underlying stock – it’s affected by several different parameters, including market volatility and the amount of time left before the option expires. Like shorting a stock, it’s a technique used best by experienced investors with a short timeframe.

The bottom line is that while it may be appealing to make money as a dividend growth drops in price, there are several hurdles involved to doing so. In the end, unless you’re willing to spend a lot of time learning how to properly short stocks, use price drops on dividend growth investments to take advantage of the increased yield.