Here’s What This Stock’s 6% Yield Means
Income investors are celebrating the fact that yields on 10 year Treasury notes are challenging 3%. That seems high by recent standards. Of course, twenty years ago no rational investor would have considered a bond of that duration for 3%. Inflation would outpace income.
But, the Federal Reserve introduced the concept of zero interest rates and now 3% seems like it is reasonable. Low interest rate policies have also distorted the perception of some stock market investors related to their views on dividend yields.
As interest rates fell, so did dividend yields. Companies no longer have strong incentives to boost their dividends when there are alternative uses for cash from a corporate perspective. For example, dividends and share buy backs are treated the same from a tax perspective.
However, share buy backs, in theory, boost future earnings per share by reducing the denominator in the calculation. Management has a preference, at least from a behavioral basis, to reduce shares rather than boost dividends.
A 6% Dividend Might Seem Attractive
In this environment, a high dividend in a large cap name could be welcomed by income investors. Or, the high dividend could be a value trap since it may be unsustainable. Within the past year, investors in General Electric (NYSE: GE) have learned this lesson.
Now, after the recent example of GE, income investors should ask if high yields are sustainable, before they buy the stock. For some companies, like AT&T (NYSE: T), the answer might be difficult to determine.
Shares of T sank after the company released a disappointing earnings report for the most recent quarter.
In the first quarter, AT&T’s top-line revenue fell 3.6% compared to the same three months a year ago. Revenue totaled $31.8 billion, well below analysts’ expectations for revenue of more than $39 billlion.
Earnings per share of $0.85 also missed expectations but by a smaller amount. Analysts had been looking for earnings of $0.87 per share.
on sales in the neighborhood of $39.3 billion.
AT&T added 2.2 million net new subscribers to its domestic wireless networks in the first quarter. But that gain included the addition of 4.7 million connected devices, better known as connections under the Internet of Things banner.
The company added just 300,000 prepaid subscribers and lost 400,000 customers under the flagship category of postpaid contracts.
AT&T’s TV service business also failed to impress investors, losing subscribers for the DirecTV satellite service and holding steady in the fiber-based U-verse segment.
In a sign of the times, streaming video service DirecTV Now reported 27% subscriber growth during the quarter while tripling in size compared to the year ago period.
The stock price fell, breaking support.
Prices are now challenging long term support on the monthly chart shown next.
It seems unlikely that T will make a strong recovery from the recent sell off.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook, a call option should be sold.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.
A Bear Call Spread in T
For T, we have a number of options available. Short term investment options allow us to trade frequently and potentially increase our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell an May 18 $34 call for about $0.35 and buy an May 18 $35.50 call for about $0.10. This trade generates a credit of $0.25, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $25. The credit received when the trade is opened, $0.25 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $125. The risk is found by subtracting the difference in the strike prices ($150 or $1.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($25).
This trade offers a potential return of about 20% of the amount risked for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if T is below $34 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $125 for this trade in T.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.