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. I’ll be going over this strategy in detail in a free live event I’m hosting this Tuesday: My 2017 Dogs of the Dow Options Strategy. Click here to attend.
Before I get to the options strategy let me give you a little background on the Dogs of the Dow.
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 have 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.
The strategy is known as a poor man’s covered call – which is what I’ll talk about during my free live event this Tuesday. (For more info, just click here.)
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 start with one of the expected stocks that will reside in the Dogs of the Dow portfolio in 2017…
Take, for instance, the Exxon (NYSE: XOM)
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 XOM.
If we were to buy XOM shares at $90.82 per share, our capital requirement would be a minimum of $9,082 plus commissions ($90.82 times 100 shares).
If we look at GDX’s option chain, we will quickly notice that the expiration cycle with the longest duration is the January 2019 cycle, which has roughly 763 days left until expiration.
With the stock trading at $90.82, 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.
Why a delta of 0.80? It’s a little complicated, but I will be covering this information in my live event this week.
Let’s use the $70 strike for our example.
We can buy one options contract, which is equivalent to 100 shares of XOM, for roughly $22.60, if not cheaper. Remember, always use a limit order – never buy at the ask price, which in this case is $24.35.
If we buy the $70 strike for $22.60 we are out $2,260, rather than the $9,082 we would spend for 100 shares of XOM. That’s a savings on capital required of 75.1%. Now we have the ability to use the capital saved ($6,822) 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 January 92.5 strike with 35 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 92.5 strike for $0.94, or $94, against our LEAPS contract.
Our total outlay or risk now stands at $2,166 ($2,260 LEAPS contract minus $94 call). At first, the premium seems small, but on a percentage basis selling the 92.5 call premium for $94 reaps a return on capital of 4.2% over 35 days. Of course, your upside is limited to $92.5 with this trade. But hey, is it so bad to lose out on some potential upside to make a 4.2% gain over 35 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 XOM, 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 $92.5.
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. Again, if you would like to learn more about the strategy, make sure you sign up for my next webinar, where I discuss in great detail my approach to Poor Man’s Covered Call on the Dogs of the Dow.
I hope you can attend this event. It’s not just another webinar because this Dogs of the Dow options strategy will be a new portfolio in my High Yield Trader service for 2017.
And to help you get started, I will be sharing two to three trading examples live during this event. Click here to sign up.