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.
Before I get to the options strategy, let me give you a little background on the Dogs of the Dow.
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.
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.
Poor Man’s Covered Call on a Dogs of the Dow Stock
As an example, I’ll use one of the stocks that currently resides in the Dogs of the Dow portfolio . . . Coca-Cola (NYSE: KO). We’ve made 41.9% in 2017 using our Poor Man’s Covered Call strategy.
The 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 KO.
If we were to buy KO shares at $45.13 per share, our capital requirement would be a minimum of $45.13 plus commissions ($45.13 times 100 shares).
If we look at KO’s option chain, we will quickly notice that the expiration cycle with the longest duration is the January 2019 cycle, which has roughly 588 days left until expiration.
With the stock trading at $45.13, 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 $38 strike for our example.
We can buy one options contract, which is equivalent to 100 shares of KO, for roughly $45.13, if not cheaper. Remember, always use a limit order – never buy at the ask price, which in this case is $7.70.
If we buy the $38 strike for $7.60 we are out $760, rather than the $4,513 we would spend for 100 shares of KO. That’s a savings on capital required of 83.2%. Now we have the ability to use the capital saved ($3,753) 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 August 46 strike with 70 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, I want to use a very conservative example so we understand the basic risk/reward.
So again, let’s say we decide to sell the 46 strike for $0.44, or $44, against our LEAPS contract.
Our total outlay or risk now stands at $716 ($760 LEAPS contract minus $44 call). At first, the premium seems small, but on a percentage basis selling the 46 call premium for $44 reaps a return on capital of 5.8% over 70 days. Of course, your upside is limited to $46 with this trade. But hey, is it so bad to lose out on some potential upside to make a 5.8% gain over 70 days? 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 KO, is to buy two leaps in the stock 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 $46.
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.
I hope this helps give you all some additional food for thought regarding the power of options.
— Andy CrowderMy #1 Stock to Buy Now [sponsor]
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Source: Wyatt Investment Research