Today I want to teach you about a unique strategy you can use on one of my favorite long-term investments: The Dogs of the Dow.
The stock turnover in the Dogs of the Dow from year to year is incredibly small, averaging around two stocks per year. So, this strategy can be implemented at any time. It’s not necessary to wait until the beginning of each year, especially if you wish to use an options strategy like Poor Man’s Covered Calls on the Dogs of the Dow as a consistent source of income.
The Dogs of the Dow is a simple group of stocks that has outperformed the Dow over the last 90 years.
Here’s how it works.
Pick the 10 highest-yielding stocks out of the 30 Dow stocks, and equally weight the stocks within your portfolio.
After the initial set-up, all you will need to do is adjust the portfolio annually and, of course, reap the rewards. Historically, the Dogs of the Dow strategy has outperformed the larger Dow by approximately 3% a year.
It doesn’t get any simpler, right?
One of the key attractions of using the conservative strategy is that it requires very little time doing research. Simply take the 10 highest-yielding Dow Industrial stocks at the start of the year or any other period, for that matter and invest an equal sum in each stock. Then, 12 months later, the whole process starts over. Oftentimes, most of the stocks will remain on the list from one year to the next, simplifying things from an accounting perspective (no gains/losses to report) and also helping to lower commission costs.
But I have a unique alternative that is far more cost-effective and in most cases, more profitable than purchasing the 10 stocks that make up the Dogs of the Dow.
As I mentioned before, the strategy is known as a Poor Man’s Covered Call.
So how does this work? A Poor Man’s Covered Call is similar to a traditional covered call strategy, with one exception in the mechanics. Rather than buying 100 or more shares of stock, an investor simply buys an in-the-money LEAPS call and sells a near-term out-of-the-money call against it.
LEAPS, or long-term equity anticipation securities, are basically options contracts with an expiration date longer than one year. LEAPS are no different than short-term options, but the longer duration offered through a LEAPS contract gives an investor the opportunity for long-term exposure.
Other than reducing the capital required, the reason we purchase LEAPS is to minimize the extrinsic value and theta decay.
Let’s get started.
The Basics of the Covered Call Strategy
This stock exemplifies the typical characteristics that I look for when using a Poor Man’s Covered Call strategy . . . a low-beta, blue-chip stock with a long-standing history of solid fundamentals.
The next step is to choose an appropriate LEAPS contract to replace buying 100 shares of PFE.
If we were to buy PFE shares at $34.03 per share, our capital requirement would be a minimum of $3,403 plus commissions ($34.03 times 100 shares).
If we look at PFE’s option chain, we will quickly notice that the expiration cycle with the longest duration is the January 2019 cycle, which has roughly 648 days left until expiration.
With the stock trading at $34.03, I prefer to buy a contract that is in the money at least 10%, if not more. For the options geeks out there, I like to buy a LEAPS contract with a delta of around 0.80.
Let’s use the $28 strike for our example.
We can buy one options contract, which is equivalent to 100 shares of PFE, for roughly $6.50, if not cheaper. Remember, always use a limit order – never buy at the ask price, which in this case is $6.70.
If we buy the $28 strike for $6.50 we are out $650, rather than the $3,403 we would spend for 100 shares of PFE. That’s a savings on capital required of 80.9%. Now we have the ability to use the capital saved ($2,753) to work in other ways.
The next step is to sell an out-of-the-money call against our LEAPS contract.
I like to go out 30 to 60 days when selling premium against my LEAPS contract. Let’s use selling the May 34 strike with 39 days left until expiration. If we chose a stock with a slightly higher price we could go out two, three, four or more strikes away from the current price of the stock. But, the premium just isn’t there. We’ve been selling at-the-money calls on Pfizer since initiating the Dogs of the Dow portfolio at the beginning of 2017. So far the portfolio is up 12.1% while the stock has remained flat.
So again, let’s say we decide to sell the 34 strike for $0.62, or $62, against our LEAPS contract.
Our total outlay or risk now stands at $3,339 ($3,403 LEAPS contract minus $62 call). At first, the premium seems small, but on a percentage basis selling the 34 call premium for $62 reaps a return on capital of 1.8% over 39 days. Of course, your upside is limited, but we’re a using a safe, blue-chip stock to sell premium for income purposes . . . capital gains are not the goal here. But hey, is it so bad to lose out on some potential upside to make roughly 1.8% in income every 30 to 45 days? Essentially you are creating your own dividend. Plus, we have now have downside protection that we otherwise would not have if we purchased the stock outright.
An alternative technique, if you wish to participate on a continued upside move in PFE, is to buy two LEAPS in the ETF and only sell one call against it. This strategy will increase your deltas and allow half of your position to participate in a move past $34.
No matter the approach, we can continue to sell calls against our LEAPS contract every month or so to lower the total capital outlay. But remember, options have a limited life, so when we get closer to the LEAPS contract’s expiration (typically around 9-12 months) we will simply sell the contract and use the proceeds to continue our Poor Man’s Covered Call strategy.
Selling back this LEAP contract can actually be extremely profitable.
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Source: Wyatt Investment Research