Short-Term Traders Set Up a Long-Term Opportunity
Traders often behave like gunmen in the Wild West of the ninetieth century, displaying an attitude that could be summarized as “shoot first and ask questions later.” But, of course, instead of shooting they are selling. At the slightest bit of bad news, selling can be sharp.
That was the case with AT&T (NYSE: T) after the company delivered an earnings report that showed good results but fit with the belief that cord cutters were moving rapidly away from traditional cable and satellite television service.
The stock sold off on the news.
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To complete an analysis, we can start with the good news.
An Earnings Beat Shows the Stock’s Potential
For the most recent quarter, AT&T reported better than expected earnings of $0.91 per share compared to analysts’ expectations of $0.85 per share. The company’s top line fell short of expectations with reported revenue of $39 billion failing to meet expectations of $39.4 billion.
Part of the revenue miss was because cord cutters were switching away from AT&T’s DirecTV satellite service. But, traders may be overreacting since AT&T isn’t necessarily losing those customers to competitors like Netflix and Roku.
AT&T also offers a streaming service called DirecTV Now. In the most recent quarter, the company added 342,000 subscribers to that service, bringing the number of subscribers up to 1.8 million. This would indicate the company grew its subscriber base by more than 25% in the quarter, a significant boost.
And, there is room for substantial growth of that service which includes more than 170 million direct-to-consumer relationships according to comments from the company’s CEO Randall Stephenson that accompanied the earnings release.
These relationships could deliver significant profits in the long run. According to TheStreet.com, “By using data from wireless and TV networks, Stephenson said AT&T can sell targeted ads for three to five times the rates of conventional spots.”
This indicates there is the potential for higher ad revenue and there is also the potential for even more ads, “The newly added Turner networks such as CNN, TNT and TBS increase AT&T’s ad inventory by three times, he added.”
This news indicates the short term sell off could be an overreaction to the news and in the long run, AT&T could be an attractive stock based on earnings growth. In the short run, the stock could be attractive based on its dividend yield of more than 6%.
From a technical perspective, the stock is near an important support level on the long term chart.
But, buying in a decline presents significant risks to investors. An options strategy could provide a useful tool for investors who want to limit risk.
A Trade for Short Term Bulls
As with the ownership of any stock, buying T could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high prices stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for T
For T, the August 17 options allow a trader to gain exposure to the stock.
An August 17 $31 call option can be bought for about $0.30 and the August 17 $32 call could be sold for about $0.10. This trade would cost $0.20 to open, or $20 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $20.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in T the maximum gain is $0.80 ($32 – $31 = $1.00; $1.00 – $0.20 = $0.80). This represents $80 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $20 to open this trade.
That is a potential gain of about 300% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.