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More than 20 years ago, a book detailed an investment strategy that was known as the Dogs of the Dow. The idea was to buy the 10 highest yielding stocks in the Dow Jones Industrial Average and rebalance the portfolio once a year. It's based on the belief that high dividend yields are a sign of value in the stocks that make up the Dow.
That index includes 30 of the largest stocks and best-known companies in the world. There is little risk that a company can go into bankruptcy while it is a member of the Dow and that reduces the risk of buying the stocks. Some of the Dogs are expected to deliver market-beating gains and some will simply deliver a better-than-average income stream. Over time, the strategy is expected to outperform the index.
Although is an easy to implement strategy built on a simple idea, the Dogs of the Dow investment plan has worked fairly well. Since it was first published, the original strategy has matched the gains in the Dow with returns averaging 10.6% a year.
A variation of the strategy is to buy only the five lowest priced stocks from the list of the 10 high-yielding stocks. This strategy has outperformed the Dow with an average annual gain of 12.2%. In some years, the strategy beats the index, while it lags in other years. Last year, the index did a little better, gaining 7.3% compared to 6.7% for the low-priced stocks.
This year, the five lowest priced, high-yielding stocks are AT&T (NYSE: T), Pfizer (NYSE: PFE), General Electric (NYSE: GE), Intel (NASDAQ: INTC) and Hewlett-Packard (NYSE: HPQ). Based on Friday's closing prices, buying 100 shares of each stock would require an investment of about $11,864. Income from dividends would total $495, or 4.17%, at the current rates. Dividends can change over the course of the year so this amount is not guaranteed.
Rather than buying the stocks, call options could be used to benefit from the potential upside. The Dogs of the Dow strategy requires portfolios to be rebalanced once a year, so we can use options that expire in January 2014 to achieve exposure to the stock's price for one year. We would use in-the-money options that have an exercise price as close as possible to the stock's current price. The exact options are shown in the table below.
Buying these five call options would cost $1,089. If the stock prices all gain 10%, the options should be worth more than $1,586. This would be a gain of almost 45% for options investors compared with 10% for stock buyers. Even when you consider the additional 4.17% brought in from the dividends, the options still return more than three times the shares.
Because these five options would cost 91% less that owning the stocks, traders are committing a smaller amount of funds to this strategy than they would if they bought each stock. At recent prices, traders would free up $10,755 in trading capital that could be invested in something else.
The risk is limited to the price paid for the options. If all five stocks fall, the maximum amount the trader would lose is $1,089. In a bear market, holders of the stocks could lose significantly more than that.
Recommended Trade Setup:
-- Buy the five calls identified above to duplicate the Dogs of the Dow strategy-- Do not use stop-losses-- Close all trades at the end of 2013
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