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S&P Dividend Aristocrats Portfolio Part One: Introduction

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I think it's high time I get back into this strategy of dividend investing. I've long been a dividend investor, but have diverted from the path a bit with my options trading. While options strategies remain the primary driver of returns in my account, it should be supplemented with another income strategy. This has been referred to as "double dividend investing," that is, writing calls against your dividend paying positions, and it can work out pretty well in sideways markets. However, what we are seeing now is a major bull market with no clear sign that it's running out of steam. We may be reaching a top and a pullback could be coming soon, so in that respect a covered call strategy would be prudent; however, it could also cause a trader to leave lots of money on the table, as is the case with a few of my positions that were opened in the middle of the bull run.

So what's the plan now then? Basically I intend to build small positions in selected stocks from the S&P dividend aristocrats index, each a few days before their ex-dividend date, in an effort to create a monthly stream of dividend income. There was a time when I was scouring through ETF's and CEF's for monthly dividend paying securities, but soon found out that decent yield came with significant risk. Bond funds are slowly lowering their payout (HIX was one of my favorites, yield is dropping), and other income generating funds simply produce a return of capital, not a true dividend.

Because of the significant effort involved in discovering worthwhile monthly dividend funds, I shifted my focus to large, established companies with a history of growing dividends, starting with the aristocrats index. This is basically a dummy-proof strategy where you can't really go wrong as long as you have conviction in what you're buying. I do not intend to buy all the shares in the index, there are plenty of funds that attempt to do that already, I just intend to buy those with reasonable yields and payout ratios that compliment my investing strategy. Ideal securities will have fairly liquid options as well, so at the point when I can write a covered call I will consider doing so.

Weaknesses of this strategy

For the moment, the major weakness here is that all these stocks are now hitting 52 week highs, probably a bad time to buy. Sure, they could run even higher, but I think the likelihood is generally low for that, we can look at the RSI of some individual securities in the index to determine overbought conditions. This is where covered call writing comes in, unfortunately I will not be buying 100 share blocks of anything since I don't have the funds to do that and diversify. In order to remain diversified, I will be buying small blocks of shares, 10 - 20 units at a time, in an effort to build up an income base over time. This is somewhat of a weakness, but also a strength, as I'll discuss next.

Strengths of the strategy

Small share blocks protect me from drastic downside: a $1.00 drop in share price is only a $10 loss on paper for a 10 share block, where it would otherwise be $100. Sure the percentage is the same, but with a pullback being almost inevitable at the moment I feel a lot safer about buying smaller blocks. Also, two to three months from now when we get to the next ex-dividend date I can buy more at a lower price (if the market permits it). This aspect will also be taken into account in my strategy: if a stock price has run up quite a bit and looks too expensive, I won't buy more of it, I'll just keep collecting the existing dividends and wait for a more attractive entry point. However, the ideal situation is that I add a few shares every couple months, eventually building up to a 100 share block for covered call writing. The main problem, again, is that I'm buying at market highs right now, so I would prefer to average down over time. Don't know if that's going to happen.

The other strength is the quick diversification of the portfolio, already I've noticed daily gains and losses being offset by gains and losses in other securities, with a general uptrend in prices. If I had hundreds of thousands of dollars, I could of course create a diversified portfolio consisting of round hundred share blocks, and generate tremendous income from covered call writing, unfortunately I don't have that kind of money, if I did I wouldn't be writing a blog and sharing my ideas with random strangers.

What about commissions?

This is the beautiful part of my strategy, and part of the reason why it's so easy for me to buy into such small blocks of shares. In mid-2012 I opened an Interactive Brokers account and funneled all my trading activity there. My primary motivation was their low commissions: stock trades are $0.005/share, with a minimum of $1.00 per trade. Option trades are similarly prices, but vary based on which exchange the order is routed to, I'm averaging about $1.07 per trade.

This strategy helps me meet my monthly activity minimums and keeps costs down. Compare this to other brokers charging $7.95 per trade, plus a per contract charge for options. Round-trip break even points are much lower using Interactive Brokers, and even stepping into a position with 3-4 trades is still cheaper than most discount brokers. There are various points to consider with an Interactive Brokers account, it's not for casual retail investors, it's geared toward active traders and investors that manage their account on a near daily basis, so don't jump in on my recommendation unless you'll actually trade frequently enough to make it worthwhile. Based on these considerations, I will work on a separate article going over all the variables in my decision to move to IB.

What's next?

Since I intend for this to be a series of articles, the next article will focus on what I've already purchased and why, I will then follow up with the securities I am looking at on a monthly basis, as determined by upcoming ex-dividend dates.

Furthermore, I'd like to benchmark my progress against an established ETF or other index.

What do you think?

Have you done something similar? Or do you think I've missing anything or skipped any steps in this strategy? Let me know in the comments section below! I'd love your feedback and ideas. Maybe you think I should just get a dividend ETF that tracks the same index? Let me know!

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