This Dividend Machine Is Offering A Rare Chance To Profit

Zachary Scheidt's picture

Friday, May 23, 2014 - 12:00pm

by Zachary Scheidt

As a general rule, I typically avoid using a put-selling strategy with stable blue-chip stocks. The reason is these slow-moving stocks usually have very low levels of volatility. Low volatility naturally results in lower option prices, which in turn, reduces our level of profits when selling our put options.

It is always important for us to consider the level of risk we are taking with our trades, and compare that risk to the level of income we expect to generate. The good thing about selling puts on blue chips is our level of risk is usually very low. Unfortunately, an anemic level of income makes it somewhat pointless to take these trades when we could be using the capital in more productive areas.

Today, we have a unique chance to set up a new income trade on a blue-chip stock that has recently experienced more volatility than usual. In fact, a major transaction is pending that has resulted in a degree of uncertainty among traders. This uncertainty is boosting option premiums, giving us a more attractive level of income despite the underlying stability of this company.

AT&T (NYSE: T) made headlines this month when it announced an agreement to buy DirecTV (Nasdaq: DTV) in a deal valued at $67.1 billion. While the deal will have to be approved by various regulators and will almost certainly face some challenging hurdles, a combination of the two companies would definitely result in synergies -- and a likely boost in profits.

Shares of AT&T moved lower last week, primarily as a result of merger arbitrage pressure. When a big merger like this is announced, many hedge funds set up a trade in which they buy the stock that is being acquired and sell the stock that is making the acquisition. This trade represents a hedged bet that the merger will go through as opposed to a directional bet on whether the combined company will trade higher or lower.

The arbitrage pressure has essentially helped us as put sellers in two ways. A modest decline in the stock naturally sends put option prices higher and gives us a chance to set up our trade at a lower price point, meaning potentially less risk because the stock has already backed off. Additionally, the added volatility and uncertainty from the deal helps us because it boosts the volatility premium that is included in the price of the options.

While it would normally not be possible to generate an attractive level of income by selling puts against blue-chip AT&T, today we have an opportunity to set up a relatively safe 14% a year return.

Action to Take --> To initiate the trade, we will sell the T July 35 puts, which were trading near $0.80 as of this writing, using a limit order at $0.75 to ensure an acceptable level of income. By selling these puts, we will have an obligation to buy 100 shares of AT&T per contract at the $35 strike price if the stock is trading below this level when the puts expire. 

To initiate the trade, we will need to set aside capital in our account to cover this obligation. Since we are collecting $75 for each contract we sell, we will only need an additional $3,425 per contract.

If T is above $35 at expiration and the puts expire worthless, our $75 represents a 2.2% return over the capital set aside in 57 days. This equates to a per-year rate of return of 14% -- a very attractive level of income given the stability of this stock.

If AT&T continues to decline and we are assigned shares, the resulting trade should still carry a low level of risk. Our cost basis will be $34.25, and the stock currently has a 5.2% dividend yield. The company is cash-flow positive with strong prospects, especially considering the pending DirecTV deal.

Whether our puts are exercised or not, this opportunity appears to be one that will give us an exceptional level of income while keeping our risk at an acceptable level.

This article was originally published at ProfitableTrading.com: 
Blue Chip Offering a Rare Chance to Generate 14% in Income

 

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Zachary Scheidt does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of T in one or more of its “real money” portfolios.