How do U.S. stock exchanges specifically account for dividends and ex-dividend dates?

Question

At another question about ex-dividend dates and withholding taxes, an answer from Bob Baerker says:

Stock exchanges reduce share price by the exact amount of the dividend on the ex-dividend date [...]

On first reading, my inclination was to interpret "stock exchanges" to generally mean "stock markets" — i.e. implying the collective outcome of the many (mostly) rational participants in a well-functioning market. Participants set the bid and ask prices for a given stock, and would reflect such things as dividends paid (which reduce the value of a company, and therefore its current stock value.)

However, a further comment from Bob on another answer got me questioning my initial interpretation, as it specifically disambiguates the markets from the exchanges:

It's not a question of the markets pricing it correctly. The stock exchanges reduce share price by the exact amount of the dividend on the ex-dividend date, prior to the resumption of trading.

... meaning to me that, above and beyond what a market's participants may do, the stock exchanges have some kind of role in adjusting/reflecting share price around an ex-dividend date.

My question is:

How exactly do stock exchanges in the U.S. reduce share "price" when it comes to dividends and the ex-dividend date? (I put "price" in quotes because share "price" is an imprecise term.)

I presume (CMIIW) that bid and ask prices always and only result from market participants (potential buyers and sellers, market makers, etc.) who freely choose the prices at which they're willing to transact — and again, rational participants would tend to account for dividends paid out.

So what is the exchange itself doing with respect to "price" to account for dividends paid out?

Is the adjustment to price referring to last or closing prices only? Is such adjustment really just about the data that the exchange provides to brokers, news sites, and so forth? And to what end do exchanges do this? What would be the consequence of not adjusting prices in that way?

Answer 1

A statement made by many is that the market determines share price change on the ex-dividend date. This is supported in an article at Investopedia:

On the ex-dividend date, investors may drive down the stock price by the amount of the dividend to account for the fact that new investors are not eligible to receive dividends and are therefore unwilling to pay a premium.

Other web sites state that the specialist/exchange marks share price down. From Zacks:

Stock market specialists will mark down the price of a stock on its ex-dividend date by the amount of the dividend. For example, if a stock trades at $50 per share and pays out a $0.25 quarterly dividend, the stock will be marked down to open at $49.75 per share.

Who should you believe?

Let's look at some stocks going ex-div tomorrow morning. The number in parens is the dividend, followed by today's close:

• ESS (1.95) $288.30
• AVB (1.52) $201.28
• WPC (1.03) $ 81.30

Tomorrow morning, look up the closing before trading resumes. The closing quote (technically the adjusted close) will be lower by the exact amount of the dividend. If trading has resumed, subtract the price change from the last price and that will give you the adjusted close.

If this ex-dividend share price adjustment did not occur, everyone would place MOC orders (market on close) this afternoon to capture the dividend overnight and then sell immediately in the morning, making free money. No one would ever need to trade anything else. There is no such arb yet there are numerous web sites and newsletters dedicated to hyping the idea that Dividend Capture provides free money. It’s bogus.

The idea that dividends are income and you can live off of them in retirement is also bogus. Because share price is reduced by the exact amount of the dividend, it creates an equal and offsetting capital loss, resulting in zero total return (before dividend taxation if non sheltered). It reduces your money at risk by returning a portion of your investment to you. Let's not get sidetracked by 'dividends come from corporate earnings". This is all about what happens in your brokerage account on the ex-div date.

As a no return example, if you bought AT&T exactly three years ago at $42.03, you would have received $5.94 in dividends. Say you spent them to live. Your position has lost $9.48 and you are net down $3.54 at yesterday's close of $32.55. The dividends received simply lowered your break even to $36.09. This is metaphorically no different than withdrawing cash from the bank and spending it for living expenditures. The dividend does not become true income until share price recovers by the amount of the dividend (slightly less if dividends are reinvested). Only share price appreciation provides total return.

Stock exchanges reduce share price by the exact amount of the dividend on the ex-dividend date so if one does nothing and the security is held in a non sheltered account in the U.S. then all one would gain would be a taxable event and negative total return. Most retail traders and investors are not aware of this and have no clue what's going on in their own brokerage account(s).

Further supporting this exchange adjustment mechanism is FINRA Regulation 5330 which is "Adjustment of Orders":

(a) A member holding an open order from a customer or another broker-dealer shall, prior to executing or permitting the order to be executed, reduce, increase, or adjust the price and/or number of shares of such order by an amount equal to the dividend, payment, or distribution on the day that the security is quoted ex-dividend, ex-rights, ex-distribution, or ex-interest, except where a cash dividend or distribution is less than one cent ($0.01), as follows:

(1) Cash Dividends: Unless marked "Do Not Reduce," open order prices shall be first reduced by the dollar amount of the dividend, and the resulting price will then be rounded down to the next lower minimum quotation variation.

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EDIT: 7:00 AM EST (the next morning)

Here are yesterday's closes with the dividend in parens:

ESS (1.95) $288.30

AVB (1.52) $201.28

WPC (1.03) $ 81.30

Here are the closing prices listed this morning before trading has resumed:

ESS now displays a close of $286.35

AVB now displays a close of $199.76

WPC now displays a close of $80.27

$1.95, the amount of the dividend, has magically disappeared from the closing price of ESS overnight.

$1.52, the amount of the dividend, has magically disappeared from the closing price of APC overnight.

$1.03, the amount of the dividend, has magically disappeared from the closing price of WPC overnight.

QED

Answer 2

I believe that the confusion here may be the result of mixing up two different types of prices - what we might call "official" prices and "market" prices.

The exchanges issue official prices. They issue an official closing price and an official opening price. These prices are used by the various brokers and clearing houses to value their positions and to calculate margin requirements. These are accounting functions and administrative functions. In this context, the exchange does adjust prices by the dividend amount at the opening of the ex-dividend date.

On the other hand, market prices reflect what market participants are willing to pay. Nobody is obliged to buy or sell at the official opening price. You can place an order to buy or sell at the open, but there is no guarantee that there will be a bid/offer at the official opening price.

TL/DR;

Statistical analysis suggests that the market is inefficient in this regard, showing a preference for under-adjustment by the dividend amount. Some see this as an arbitrage opportunity.

Answer 3

Even if the exchanges were to try to automate or facilitate the expected price drop, it wouldn't accomplish much because the only real price is what traders are willing to trade at, and traders assess additional factors anyway in pricing a newly ex-dividend stock, and would end up working around whatever the exchange does.

The last trading in a stock before it goes ex-dividend is in the after-hours session the day before ex-dividend. The first trading in the ex-dividend stock is in the premarket session on ex-dividend day. Thus, trading does not suddenly switch to ex-dividend; at least 8 intervening hours pass with no trading and no live bid/ask. During that time, even if there is no company-specific news, developments in geopolitics, the economy, and the pertinent industry change the value traders place on the stock above and beyond the ex-dividend effect. This is why prices change from a market close to the following open even with no dividend involved.

To observe the dividend effect from stock prices alone is a statistical matter; collecting many observations, some with positive overnight news and some with negative, would reveal an average price drop equal to the dividend. (The dividend effect is seen in pure form in pricing of derivatives like futures and options that depend on the expectation value of the ex-dividend price, before the additional news affecting it is known.)

Precisely because of this overnight risk, the dominant professional traders, including market makers, do not typically leave buy or sell orders standing overnight (on any night, not just before ex-dividend). Rather, they want to make a fresh assessment as the stock prepares to open for trading. In any particular ex-dividend instance, the resulting initial prices (bid/ask and trades) are a result of the dividend effect plus the other factors.

A relatively few orders from longer-term traders/investors are good-till-canceled (GTC) and could live across a dividend. Most of these people would consider it their responsibility to beware of dividend effects (dates and amounts known in advance) so as not to, for example, get stopped out by a price drop due to a large dividend that wouldn't correspond to the reasons they set up the stop-loss. Some brokers and/or exchanges might, as a convenience, have a policy of adjusting prices of standing GTC orders on ex-dividend days. But such orders are not the dominant influence on stock pricing.

The idea that the exchange has a necessary role in promoting rational ex-dividend pricing seems to imagine that a stock's opening order book is largely inherited from the previous close. Instead, the majority of the order book disappears overnight and is constructed fresh in the morning by traders who are performing the adjustment themselves along with all their other calculations.

Answer 4

Dividends are announced by the company in advance of when they are paid.
As a result, the day the stock goes ex-dividend, it is a near-certainty what the stock price should be adjusted by to take into account that if you bought the stock yesterday, you would receive a dividend, but if you bought it today you wouldn't.

The exchanges don't usually play an active role in adjusting the price for dividends, but enough sophisticated investors (including the specialists and market makers) take the dividends into account that they adjust the price of their orders to buy and sell accordingly resulting in the dividend price jump.

Some brokerage and exchange systems will take dividends into account when handling customer orders and will apply the changes automatically (such as the one the OP is referring to). However this is not all systems. Your broker would be able to advise you whether their system does this.

Answer 5

In the USA, broker-dealers will reduce the prices of their customers' open orders by the amount of the dividend. This is required by FINRA rule 5330 Adjustment of Orders:

(a) A member holding an open order from a customer or another broker-dealer shall, prior to executing or permitting the order to be executed, reduce, increase, or adjust the price and/or number of shares of such order by an amount equal to the dividend, payment, or distribution on the day that the security is quoted ex-dividend, ex-rights, ex-distribution, or ex-interest ...

FINRA copied the rule from the Nasdaq stock market's rule book, where it is known as rule 3220. Other stock exchanges may have similar rules in their rule book.

The NYSE used to have a similar rule known as rule 118:

Rule 118. Orders To Be Reduced and Increased on Ex-Date

When a security is quoted ex-dividend, ex-distribution, ex-rights or ex-interest, the following kinds of orders shall be reduced by the value of the payment or rights, and increased in shares in the case of stock dividends and stock distributions which result in round-lots, on the day the security sells ex:

(1) Open buying orders;

(2) open stop orders to sell

[...]

In 2015, the NYSE removed rule 118 when it ceased to directly support Good Till Cancelled (GTC) and stop orders. It is my understanding that GTC and stop orders are still allowed at the broker level, just that they are no longer directly provided by the NYSE.