Insuring Against A Correction Without 'Missing Out' On Upside - A Modified Dogs Of The Dow Strategy

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Includes: CVX, DIA, IBM, PFE, VZ, XOM
by: Mike Vethacke
Summary

Those concerned about a stability of the current market rally desire a strategy that protects against a correction while still allowing participation in further market upside.

I propose a strategy loosely based on the well-known "Dogs of the Dow" approach, using Dow ETFs.

Adding options positions should provide insurance against Dow declines, while maintaining exposure to market gains.

The Dow volatility index affects options pricing, but hasn't been well-correlated with actual year-ahead Dow movements. Therefore timing is possible by buying options on the index's dip.

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Step One - Modified "Dogs of the Dow"

The foundation of this proposed strategy is a long position in the five highest yield components of the Dow. This is a derivative of the even more well-known "Dogs of the Dow" approach. This is discussed in length elsewhere and involves taking long positions in the 10 highest yielding Dow names. The logic is: all other things being equal, this subset of the Dow contains companies who carry lower risk and/or are relatively undervalued; resulting in lower share prices and corresponding higher yields.

Typically, the positions are initiated at the beginning of the year. I have restricted my selection further to just the top 5 yielding stocks, since it is less time consuming and cheaper to manage 5 positions than 10. Obviously, holding fewer stocks results in less diversification. But as will be seen later in this article, I expect sufficient diversification to come via options positions.

Historical Performance

Over the last 22 years, investing in the Dow's 5 top yielders has generated significant outperformance vs. the Dow as a whole. A comparison on returns by year as well as statistics for the 1996-2017 period are shown below. This approach beat the Dow in 14 of the 22 years, and the median annual total return beat the overall Dow by 270 basis points/year (annual return history courtesy of Dogs of the Dow):

5 Hi Yielders Dow
STDEV of returns 17.6% 15.6%
Min return -44.2% -33.3%
Max return 40.9% 32.9%
Avg Return 12.2% 10.6%
Median return 15.5% 12.8%

Source: Author calculations

So, What's Not to Like?

Given the above data, why not just go long on the Dow's top 5 yielding stocks and call it a day? First, the historical outperformance does come at a cost. As the data in the table above shows, the volatility of this strategy by itself is high at least relative to the Dow as a whole -- as measured by both the standard deviation and the overall range of returns throughout the last 20-plus years. This is not overly surprising, given that being exposed to 5 stocks as opposed to the entire Dow's 30, means there is less diversification across industries.

Second, while investing in the highest yielding subset of an index can be seen to be mildly contrarian, in actuality the returns are highly correlated to that of the overall Dow. As can be seen from the bar chart, when the Dow is down for the year, these high yielders tend to be down right along with it. This leads us to look for appropriate ways to hedge the positions, especially if we are concerned a market correction is on the horizon.

Step Two: Bringing Options Into Play

The search for a hedging strategy leads one naturally to options. Specifically, I propose initiating a long strangle (simultaneously buying a call and a put), which pays off in the event of significant Dow volatility either up or down. In my case, I selected both a put and a call expiring Jan. 18, 2019, with strike prices just above (for the call) and below (for the put) the current Dow ETF price of $254.93. As of market close Feb. 2, 2018, a 255 Jan 19 call is priced at $15.50, and a 255 Jan 19 put is $12.55. This results in a total price of $28.05/share. This is effectively a "cost" of about 11% of the underlying index price.

What About the "Puppies of the Dow" Instead?

A well-known derivative of the "Dogs of the Dow" strategy is the so-called "Puppies of the Dow" approach. This involves taking the 5 lowest cost Dow components. This is close to, but not the same as, taking the 5 highest-yielding stocks. Why did I not choose the "Puppies of the Dow" route? One reason is that by not selecting solely based on share price, I avoid entering positions in toxic companies with cash flow issues, whose share prices could be beaten down for very good reasons. Another reason is more pragmatic: The yields are partially offsetting cost of the options I added to the portfolio. The higher the yields, the lower the effective carrying cost of this strategy.

To Summarize

I proposed a 2-step process consisting of long positions in the 5 highest yield Dow components, equally weighted, with a long strangle layered on top. The size of the strangle was such that the total dollar exposure to the underlying Dow index, was equal to the total dollars invested in the 5 stocks. The positions are summarized below; note that I based the selection of the 5 stocks on estimated yields as of Dec. 31, 2017. In addition to the costs of each stock, at the outset I also paid roughly 11% of my long position for options, which will pay off in case the index moves significantly up or down through January 2019 (closing prices taken from Yahoo Finance):

Feb 2 Close Yield % # Shares or Contracts Position
VZ $ 52.98 4.4% 190 $ 10,066
IBM $ 159.03 3.7% 65 $ 10,337
PFE $ 36.61 3.7% 275 $ 10,068
XOM $ 84.53 3.5% 120 $ 10,144
CVX $ 118.58 3.5% 85 $ 10,079
Jan 19 255 Call DIA $ 15.50 2 $ 3,100
Jan 19 255 Put DIA $ 12.55 2 $ 2,510
Total Cash Out $ 56,304

Why Options Now?

I am certainly not the first one to propose "insuring" a long portfolio with strangle type options, and of course it is entirely possible they could impose a drag on returns by expiring worthless. However, I think considering options was particularly timely at that point, given the Dow's volatility (as measured by ^VXD) was relatively low by historical standards (see chart below). This is important because this volatility expectation is an input into options pricing. The fact that it was relatively low, implies the options are bargains right now (historical volatility taken from Marketwatch):

But Weren't Options Fairly Priced Already?

Some may read my previous paragraph and take an opposite view: they will say options were not really "cheap" since today's put/call premiums already incorporate all rational expectations about future Dow volatility. In other words, today's low options pricing is reasonable in the context of expected future volatility in the underlying Dow -- implying options are not "bargains" but are already fairly priced. The problem with this logic, is that today's volatility measure, at least as expressed by the ^VXD, has had little correlation with actual movements in the Dow index over the course of the next year (see chart below). Therefore, in my mind, low options prices do not signal low volatility of the underlying index over the next 12 months.

Source: Author calculations

Projected Payoffs

The chart below shows estimated payoffs of my proposed strategy vs. simply going long on the overall Dow. This assumes capital gains on my long positions the Dow's 5 highest yield stocks will roughly correspond to the overall Dow. This is fairly conservative in light of recent history, where as noted above, that subset of the Dow has outperformed the large index. Generally speaking, if the market drops by over about 10%, this strategy would beat the Dow because it puts a floor on losses (and could even be profitable, if the market really tanks). Conversely, if the market continues its ascent, this approach should beat the Dow because of accelerating returns from the call options. Of course, there is no such thing as a free lunch, and the additional cost of options would end up being a drag on returns if the market stays within about +/- 10% of its current level.

Source: Author calculations

Conclusion

In this article, I laid out a strategy that allows for exposure to further market gains, while also providing a sort of insurance against a market correction. This might interest investors who are uneasy about how long the current market will last, or who want to protect against a significant catalyst for future market volatility.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DIA, XOM, PFE, VZ, IBM over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.