I have been taking a closer look at AT&T (NYSE), thinking about what to do with it. The first reason I’m thinking about it is that juicy 6.8% dividend. Thinking: Why not just pile in some money and sit on it for a while? Obvious answer: risk of capital loss.
Now, I realize AT&T is not the most volatile stock. But look at Toyota: Shit happens. What if you wake up some morning and iPhones are exploding, Luke Wilson gets put in jail, and you are forced to sell the stock at $20, logging a 16% loss.Then that 6.8% dividend would not compensate you for the risk.
So I thought about how to collect the dividend and hedge the stock. What if you could buy a bunch of AT&T stock, collect the dividend, and sell some covered call options as a hedge? That might be a decent strategy. For those not familiar with covered calls, what you do is you sell the call options (an option to buy the stock at a higher price), selling an equivalent number of options on the shares that you own. That upside of this strategy: You are collecting premium on the options in addition to the dividend, if the stock stays below the excercise price. The downside: If the stock takes off, you will have to buy those calls at a higher price, or tender your shares (hence, the “covered” calls), thereby capping your upside.
A covered call strategy is used by many hedge-fund players to add “alpha” or return to low-risk stocks that they think will not move. For example, say there is a stock like AT&T that pays a 6.8% dividend that you think won’t move much, either direction. You would buy the shares, collect the dividend, and sell calls every month above the price of the stock to collect option premium.
Then I looked at the options on AT&T. There is almost no premium in the options!
The March AT&T calls with a $26 strike price (only $1 above the current price) are selling for only .03 cents. If you sold 1,000 calls you would collect only $30 in premium. Now, I am by no means an option expert. But it’s not often that you see options with a strike price only $1 higher than the share price with the expiration weeks a way selling for .03 cents.
Below is the chart of Thursday’s option prices on AT&T, for those expiring on March 20.
|Options Expiration: March 20, 2010|
These option prices are low. In fact, they seem to imply that the market sees the stock barely moving at all in the next few weeks — not even by $1 or $2.
The puts in AT&T are equally lacking in premium. Basically, the market has priced in little to no volatility for AT&T. This is actually good for my dividend strategy, because it means I could buy the stock and hedge with puts, buying the insurance almost for free.
So, back to the trade. What to do? With the market pricing in no volatility, the dividend seems like not such a bad idea. But my idea on hedging has changed since looking at the option prices. Instead of selling the call options, I could hedge the entire stock position by buying the put options for almost nothing. So here’s the trade I carved out on paper:
Buy 1,000 shares of AT&T. Cost: $24,000.
But 10 put contracts with a $23 strike price. Cost: .04 per share, or $40 to protect 1,000 shares for a move below $23 (the market apparently thinks there is almost no chance of this happening — but it also believes there is almost no chance the stock will move above $26).
Now, of course, you would have to roll the options each month. But it looks to me like the next month’s premiums are not even much higher. For example, the $22 put strike for options expiration in April is only .08. So apparently the market doesn’t expect AT&T stock to move much next month, either.
What about the dividend? Well, it’s quarterly, so you wouldn’t collect your first dividend until May, probably (in 2009, AT&T paid the quarterly dividend on May 1). Even if the cost of the insurance on 1,000 shares jumps, you’ll still be covered by the dividend. And if the put options rise, well, you own them, so you could sell them to offset the loss on the stock.
What about the stock chart? Interestingly, shares sold over sharply right after the last dividend date, in January. This adds to the strangeness in the options pricing, because as I look at the chart, AT&T has moved within a $5 band between $23 and $28. The options are priced as if the stock will never move more than $2. Doesn’t look like this is the case.
Okay, so I’m going to buy 1,000 shares of AT&T and hedge the position with an equivalent number of puts, at about a $23 strike price, for a $40 insurance cost. We’ll be rolling this option protection every month (which will probably cost about $30-$50 per month), and aiming to collect the dividend.
Anything else? Yes, in fact, the call options are so cheap — and seem irrationally so — that I’m going to buy 5 April $26 calls at .13 cents. as well. It’s a cheap trade: Five contracts will set you back about $65. But you know what? If AT&T moves any more than $1 higher within the few months, that will make you money: Both on the shares that you hold, the dividend, as well as the options. If the stock moves toward $26 or $27 you will likely be able to sell those options you bought for .12 for closer to $1 or more.
This entire trade package would set you up to capture upside in the stock, as well as the dividend . You are almost entirely protected from downside moves in the stock by the combination of the dividend and the put options which you buy each month (insurance).
In fact, the only way real way you would lose any money on this is if the stock stays in a band between $22 and $25 between now and April, your put options expire useless, and you are forced to sell the stock in the “no-man’s land” of between $22 and $24. In that very scenario, your puts insurance is useless, and you will lose that insurance money (probably around $100 or so), plus the 1,000 shares of stock you own is now only worth $23,000. You will collect the dividend, though, so your total paper loss would be between $1,000-$2,000, depending on the exact size of the dividend and when exactly you sell.
Now, keep in mind, you would have to be a terrible trader to do this, you would almost have to time it perfectly to wait until your options expire and specifically try to sell your stock at $23.
What’s the upside to the trade? Well, let’s say that near the dividend date the stock moves back toward the December high of $28. Your put options expire worthless, so you lose about $100 in insurance money. But now your shares are worth $28,000 and you collect the dividend, which will probably be around $400. Oh, you also could sell the call options you bought for .03 cents, probably for about $3 or more — collecting another $1,500 or more. Your total gain would be $4,500 or higher! Not bad.
What about the middling result: nothing happens? Well then, you lose about $140 in options premium but you collect the dividend — probably around $400 — with all your capital intact. You’ll make a few hundred bucks.
I realize this trade sounds complicated. Let’s call it some kind of “dividend strangle” strategy. But the thing I like about it is the risk/reward. It has a lot of upside, but the downside risk is limited.
Options sharks, please email me and let me know of the non-existent volatility pricing of AT&T options. This is quite a mystery.