When you step back and look at what’s been really going on in the market these past few weeks, it’s clear that two things are driving increased volatility and worry: trade tensions and the bond market.
First, it’s clear no one on Wall Street appreciates the brinksmanship between the presidents of the U.S. and China. This never-ending trade war and escalation has seen ripples through all of the stock market. Now, with the most recent round of tariffs on Chinese goods set to kick off by year’s end, investors are surging into safe investments.
That, as is often the case, means long-dated bonds are back in style. This flight to safety has send the 10-year and 30-year Treasury yields down to record lows. We’ve seen an inversion of the yield curve and plenty of speculation on what that might mean for the economy.
But we haven’t heard what else that might entail. You see, a sub-2% yield on long-dated Treasuries means investors are not getting any yield for their money… no income.
To find that, there’s really only one place left to look: high-yield dividend stocks. And many investors are starting to look there.
The company that tops this list, and has for quite some time, is AT&T (T). This telecom has a dominant market presence and stands to profit mightily off the switch over to 5G networks.
The company hasn’t gone unnoticed, jumping about 22% year-to-date and is sitting at its 52-week highs right now. But that might not be the end of this story.
You see, investors are now really starting to search for yield. And AT&T has it. Moreover, it is actually still undervalued compared to its historical prices.
Right now, the company’s stock trades at about 9.8 times its forward earnings. Historically, it has typically traded at about 17 times that amount. Meaning, there’s real upside left here… despite a good 2019 so far.
Its current dividend yield of 5.8% makes it about three times as lucrative for yield seekers as long-dated bonds. That’s not to say there isn’t three times more risk. But in a market without options, they will have to go somewhere.
Compared to its peers, it still looks like there’s plenty of room to move. While AT&T has had a great year so far, Sprint – which is still tied up in its own merger with T-Mobile – has equaled it. Yet this competitor is trading at much higher valuations, around 17 times earnings.
This presents a unique, short-term opportunity for smart traders. Instead of diving into shares of T, hoping to front-run those yield seekers, there’s a way to play it while also limiting the amount at risk.
A Strategy For Short Term Bulls
A bull call spread is a type of options trade that involves buying one call option on a stock you believe is set to rise and selling a second call with a higher strike price to reduce the amount at risk.
The income from that sold call helps offset the cost of buying the first one. This reduces the cost of the trade and therefore the amount at risk.
Now, this risk reduction does have a drawback. It also caps the total amount of profit you can make on the trade. Buying a call without selling a second one offers unlimited profit potential. But it is also much more costly.
You can see how this plays out here:
Source: The Options Industry Council
For AT&T, this tradeoff is worth it. Despite its deep undervaluation and the market forces set to bring its share price higher, it is not likely to double overnight anytime soon.
So, giving up some upside in the event of a massive rally is worth it. And that risk reduction is, after all, what everyone is seeking these days.
Let’s look at a specific example of a bull call spread on shares of T…
A Specific Trade For AT&T
Right now, a trader could buy an October 18 $35 call on T for $1.09 per share and sell an October 18 $37 call on T for $0.28 per share for a total cost of $0.81 per share. Since each call is worth 100 shares of the stock, that’s a total net debit of $81.
That’s it. That’s the total amount at risk for this trade. If shares some how sink from here, that’s how much the trader stands to lose. Though, that’s unlikely considering the upside left in this trade.
The maximum potential profit is far greater. To find that, take the difference in strike prices ($37 – $35 = $2), and subtract the cost ($2 – $0.81 = $1.19). In other words, if shares tick up just a little bit, the trader would pocket $119 on the $81 he put at risk.
That represents a potential return of 147% on the amount at risk for this trade. Considering shares only have to jump from just over $35 to $37 to lock this in, that’s a tremendous opportunity.
Basically, the trader is looking at a 147% return if shares of AT&T move just 5.7% over the next two months.
To put it another way, instead of trading at 9.8 times its forward earnings, T carried just a 10.4 forward P/E… this trade would more than double in value. That’s not a large move by any means in a market desperate for yield… and 5G technology.