All year long AT&T Inc. (NYSE:T) has been trading in violent moves, but mostly off headlines involving T-Mobile US Inc (NASDAQ:TMUS) and Verizon Communications Inc. (NYSE:VZ). Yesterday, T fell a massive 6% on the heaviest selling day in years.
The headline started by questioning operational challenges in churn, but then it quickly took a turn towards financial uncertainty. Specifically, experts raised the possibility that AT&T might need to cut the dividend.
Historically, dividends are sacrosanct. Meaning when they get cut, those stocks will get hammered because it’s a matter of math. Also there are funds that would no longer be allowed to hold T stock without a dividend. So the downside threat in that hypothesis is real.
From a trading perspective, once the rumor is out, traders are quick to price most the damage into AT&T stock. So, in spite of the danger of being too early, I don’t mind risking some money now to try and catch this falling knife.
Instead of risking $35.80 at face value and have no room for error, I will use options. There I can establish a moat around my risk. The idea is simple. I commit to buying the shares much lower than current price and for that I collect a premium. If time passes and AT&T stock stays above my level, then I keep the premium as profit.
Expectations on Wall Street are underwhelming. T stock is now trading well below the lowest of the price targets. In fact it’s trading 15% lower than the average. Furthermore, most analysts have a HOLD rating on it. This creates a conundrum.
Either the analysts will downgrade their price targets to catch up with the lower reality, or they will reiterate their prices in defense of the stock. Obviously the first will be bad for bulls. That’s why I’d rather use options to catch this falling knife just in case there’s further room below.
Consensus will most likely shift negative. It is a process so there will be more bad news to come. But perhaps the biggest blow is already in. So the key to today’s strategy is that I am willing and able to own AT&T shares at a discount.
Fundamentally, T stock is not outrageously expensive with a price-to-earnings ratio of 16x. Furthermore, its price-to-book ratio is under 2. Therefore, it’s not likely to be a massive mistake to own shares at a discount from today’s prices. Sure, the dividend aspect is in danger but the stock was punished severely by the rumor.
Technically, this is not an obvious bullish entry point. But it is inside a zone that has been pivotal for over five years. So the bulls and the bears will want to put up a good fight. This could create a stall and that would serve my trade well.
I am realistic with my expectations. Logically, this malaise is likely to linger, so expecting a spring back is not realistic. On the other hand, I am not in a rush to see a rally. All I need is for the slide to slow.
The trade: Sell the T Apr 2018 $31 put for 60 cents. This is a bullish trade that has an 85% theoretical chance of success. But if the price falls below my strike, then I own the shares and I would suffer losses below $30.40.
For those who want to mitigate the risk of selling naked puts, they can sell a spread instead.
The alternate trade: Sell the T $31/$29 credit put spread where I have the same odds to yield 13% on risk. Neither of my setups require a rally to profit. In fact, I would retain maximum gains even if AT&T stock falls an additional 13%.
Ultimately, regardless of how careful I am, investing in stocks is fraught with danger, so I never risk more than I am willing to lose
Learn how to generate income from options here. Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him as @racernic on twitter and stocktwits.
