Selling Puts On The Dogs Of The Dow

Introduction

I have previously written about selling puts on certain sectors such as reinsurance industry and offshore oil drilling. I wanted to expand that to another area I have been working on for a few years: selling puts on out of favor members of the Dow Jones Industrial index. There are several strategies for identifying these out of favor stocks, and perhaps the most widely familiar is know as "Dogs of the Dow" strategy. The strategy has been reviewed elsewhere, but in summary it involves purchasing the four or five Dow stocks with the lowest share price, out of the ten highest yielding Dow stocks.

This conveniently narrows the universe of stocks from 30 industrial stocks down to a handful. For a personal investor with limited free time but a desire to self-manage their investments, that has a lot of appeal to me. That's ok with me, I was really interested in using it as a stock screening tool.

Fundamental Analysis

The rationale behind the Dogs of the Dow strategy is that different stocks and sometimes entire sectors become out of favor and lag the market. One way of identifying this is by comparing yield among stocks. Capital finance theory, and decades of market history, indicate that companies are reluctant to lower their dividends and thus dividend yield tends to be a fairly consistent number in the short term. Thus, the Dogs of the Dow strategy uses dividend yield as the first screen. I believe this gives the strategy some added appeal for yield-oriented investors. Furthermore, the focus on dividend yield also helps dampen the market moves of the stocks since they contain this income stream and are often held for decades by long-term term yield-oriented investors.

Another part of the rationale behind Dogs of the Dow is that only the largest companies achieve the size and scale necessary to be added to the Dow Jones Industrial index, and while the industries are cyclical and companies will run into periodic difficulties, it is felt unlikely that they would actually go out of business. There are some noteworthy near-failures such as Kodak and AIG - proof the ANY strategy with stocks will have risk. Thus the importance of diversifying this risk by holding multiple companies, and using careful analysis, and in my case - purchasing at a further discount by selling out of the money put options, as discussed below.

Buying the Dogs of the Dow at a Discount

What I have been doing is taking the DOD a step further and selling out-of-the-money (OTM) puts on these stocks, rather outright purchasing of the stocks. I am using a cash-reserved put strategy, meaning I have the money set aside in short term bonds to purchase the stocks, should that become necessary. In most cases this would require a 5 to 15% drop in share price. For me, that gives me a safety margin in knowing that I wouldn't be purchasing the stocks unless a modest drop first occurred. In other words, I can buy the same stocks at a potential discount. Oh yes, and there is the put premium too - I get that no matter what. Keep in mind that the stock prices won't always drop and this means sometimes you'll be left out of the stock position. Note that it is hard to backtest a strategy like this, because of the multitude of different expirations and strike prices one could select, and also the lack of readily available historical option prices.

The strategy is rotational in nature, meaning that if you perform this every 6 - 12 months with the current Dogs of the Dow, eventually markets will change and different stocks will languish at different times. Over time, this helps diversify the portfolio. In essence, the Dogs of the Dow is the selection strategy, and selling the out of the money put is the entry strategy.

A strategy wouldn't be complete without an exit strategy, and for this I like to sell covered calls one or two strike prices out of the money on any stock positions that I acquire through exercise. This is summarized below.

Managing the positions

There are three choices available once a position is initiated by selling a put option:

1. Buy back the option (buy to cover). I typically do this when the underlying has a rapid move upward early in the life of the put contract, resulting in a rapid gain of 50%. I often will close those out at a profit to free up capital. Otherwise, you tie up the margin for a lot more time just to get the other half of the gain - and of course it can still turn into a loss.

2. Let option expire worthless (out of the money). This is the sweet spot. This frees up margin capital and results in the maximum profit potential for the position.

3. Let option exercise (in the money) - this is the part of the strategy that can keep you awake at night; make no mistake, this is where the losses can and do happen. This is not a necessarily a bad outcome, since the positions were chosen by company valuation as being desirable investments. And I generally only sell out-of-the-money puts, which implies the stock would have fallen further - presumably making it a better valuation as long as the fundamentals of the company hadn't changed. I typically will turn around and sell covered calls on this new long stock position.

Example

The current 10 Dogs of the Dow as of July 7, 2013 are Merck (MRK), AT&T (T), Pfizer (PFE), Intel Corp (INTC), General Electric (GE), Chevron (CHV), McDonald's (MCD), Procter & Gamble (PG), DuPont (DD), and Verizon (VZ). The first five companies are known as "small dogs", because they have the lowest 5 share prices of the top ten highest-yielding Dow Jones Industrial stocks.

For illustration purposes, let's say I am most interested in establishing a position in Merck . The current share price of MRK is $47.16. I would consider looking at selling puts at the $40 strike price at the longest duration possible which is currently January 2015. The bid/ask spread (while market is currently closed for the weekend) is $2.93-2.98. One could get more money for higher strikes, such as $3.65 for the Jan 2015 $42.50, and $4.95 for the $45 put. These are summarized below.

MRK Strike Price	Put Bid price
$40.00	$2.93
$42.50	$3.65
$45.00	$4.95

Table 1. Example bid prices for MRK January 2015 put options.

I often normalize examples for a dollars-at-risk amount of approximately US$10,000. For this example, that would constitute selling approximately 3 contracts of MRK January 2015 $40 puts. Taking the worst case of $2.93 per contract, that would result in premium of $879 for being willing to purchase 300 shares of MRK at $40. Total purchase price would be 40.00 x300 = $12,000 minus the $879 put premium. Not bad considering that would be a discount (avoided loss) of $2148 from what the current purchase price would be at $47.19. I say "avoided loss" because in the scenario in which the puts would have been exercised would be if the share price were below $40.00. The buy-and-holder purchasing at $47.19 would have suffered the loss down to $40.00 and beyond, while the cash-secured put seller does not lose in real terms until the share price is below the strike price (minus the put premium).

Note that I selected a conservative example by going several strike prices below the current $47.19 MRK share price. One could earn more put premium, while also having more dollars at risk of loss, by selecting higher strike prices. Also, January 2015 is still a year and a half away, and one could earn lower put premiums more quickly by selecting earlier expiration dates. My rationale for generally selecting the longest dated expiration is that it produces the highest premiums (although with the slowest decay characteristics) and helps engrain the long-term nature of things like mean reversion that the Dogs of the Dow is based upon. Around September the 2016 options should become available and one could earn higher amounts by selecting longer dated expirations. Lots of choices!

Conclusions

To summarize, what I like are the following points about this Dogs of the Dow / Put-Selling strategy:

1. Generates current income through put premium
2. Helps acquire stock at a discount to the current price, by selling out-of-the-money puts
3. Utilizes a value / mean-reversion strategy to objectivize the stock selection process.
4. Adding a covered call selling strategy on any acquired long stock positions builds in an exit strategy to help turnover the portfolio over time and harvest gains.
5. THe Dogs of the Dow method also focuses on large, dividend-paying industrial stocks which has added appeal for yield-oriented investors.

Disclosure: I am long PFE, T, GE, INTC.