Jim uses a bottoms-up approach to forecast yearly price targets for each of the 30 components of the Dow. After valuing each stock, Jim said he expects the Dow to reach 13,365 by the end of 2011. That would be an increase of about 15% from current levels.
Some investors might look to buy some or all or Jim's top 10 Dow picks separately or as part of a portfolio. The top 10 picks are Alcoa (AA), Bank of America (BAC), Boeing (BA), Caterpillar (CAT), Chevron (CVX), Coca-Cola (KO), Home Depot (HD), JPMorgan Chase (JPM), 3M (MMM) and Verizon (VZ).
In this article, I have outlined four alternative methods of playing Jim's predictions with different risk profiles through the use of ETFs and options.
Alternative One: Seek Alpha
Investors who are less bullish on the overall market might want to invest in the top-10 stock picks and go short the SPDR Dow Jones Industrial Average ETF (DIA), the ETF commonly referred to as the "Diamonds" that tracks the Dow. Through this strategy, investors would seek the outperformance (alpha) of the top stocks while reducing or eliminating overall market exposure. They can short an equal dollar amount or just create a partial hedge.
It is important to remember that the Dow is the only popular equity market index that is weighted by each share's price as opposed to being weighted by market capitalization, like S&P indices. I would thus recommend buying an equal share amount, not an equal dollar amount, of each stock.
Establishing the short positions in DIA can occur or change at any time. Investors may wait until the Dow has had some move for the year before establishing the short DIA position or using it more tactically as one's view of the market changes throughout the year.
Alternative Two: Another Way to Seek Alpha
Another alternative for those investors who are less bullish on the overall market is to invest in the top-10 stock picks and go long the ProShares UltraShort Dow 30 ETF (DXD). DXD is a leveraged inverse ETF that corresponds to twice (200%) the inverse of the daily performance of the Dow.
Hedging market exposure with DXD is less complicated than shorting ETFs in that you buy a long position to get short exposure. It does require capital for the purchase price, but it seeks to deliver two for one. The investor needs to determine how much they want to hedge and how much to allocate between the 10 stocks and DXD.
Investors should be aware of the fact that leveraged and inverse ETFs have tracking errors. In 2010, DIA was up 12.6% while DXD showed a loss of 29.5% (that's 4.3 percentage points too many in the loss column). Part of this is due to DXD's annualized expense of 95 basis points.
Alternative Three: ETFs and Options
An investor could buy DIA and sell covered calls on out-of-the-money options on the ETF. The premiums received on the call options could provide incremental returns as long as the market stays in the anticipated range. Assuming the expected 15% return occurs somewhat straight-lined over the year, the investor would sell options with strike prices 4% to 5% above the prevailing price with expirations two to three months out.
If the options expire out of the money, the investor would continue to write options with similar characteristics. If the market moves up more than anticipated, the investor might incur a loss and buy back the expiring options and sell others with a higher strike price and later maturity date. As of Dec. 31, 2010, DIA was at $115.5 and the premium on a February option with a $120 strike price was about $0.60. A call expiring in March with the same strike price was selling at about $1.40.
The repeated sale of DIA options with similar characteristics would yield 5% to 6% annualized returns. The investor would also earn any amount DIA moves from its original price to the out-of-the-money strike price. Actual premiums earned throughout the year will vary with market volatility and the amount the calls sold are out of the money.
An investor less concerned about market downside could add returns by selling out-of-the-money put options on DIA. Though the sale of covered calls limits upside on the overall portfolio, the sale of puts has significant downside exposure.
Alternative Four: Stocks and ETF Options
Yet another alternative would be to buy the top-10 stock picks and sell out-of-the-money call options on DIA. Though this is not a covered call strategy, it would allow the investor to seek the alpha on the top-10 stock picks while earning some premiums if the Dow stays in an expected trading range. The options premiums serve as a partial hedge against an underperforming Dow but limit upside on the combined positions if the Dow outperforms.
At the time of publication, Paul Mazzilli held no positions in the stocks or issues mentioned.
Paul Mazzilli has more than 35 years' experience in the investment business. He is currently an independent fund consultant and a senior adviser and member of the advisory board at IndexIQ. He also is a senior adviser to S-Network Global Indexes and chairman of the Index Committee for the S-Network Composite Closed-End Fund Index. From 1997 to 2008, Mazzilli was director of Morgan Stanley's ETF research team, covering index-linked ETFs and actively managed closed-end fund companies.
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