If you live in the U.S., chances are high that you have either an AT&T or Verizon phone plan. The two companies, at least on the mobile phone subscription side, are very similar in size and performance.
So, why does their comparison chart for the year look so different?
As you can see, the two companies broke apart in June. That’s right when AT&T’s acquisition of Time Warner closed. A few things you need to know about this deal before we can move forward…
Time Warner’s assets include Turner, HBO and Warner Bros. These are huge names with major audiences. Just think of how big the rights to Harry Potter and Game of Thrones are.
More importantly, this deal will grow AT&T’s Entertainment business to about 25% of the company’s total revenue and 15% of its bottom line.
This all came at a high price, however. The $85 billion deal brings the combined company’s total debt outstanding to $183 billion.
This is such a large number that it has clearly scared off many investors from the moment the company completed the deal. After all, many investors buy AT&T for its large 6.4% dividend. With debt that large, paying out a dividend could be tough.
That is, however, the company’s plan. Just last week, CEO Randall Stephenson told analysts that the company’s discretionary cash flow next year – totaling about $26 billion – will all go to repaying this debt. But that will still leave plenty of room to keep paying out its quarterly distribution.
Obviously, this is just a dent in the massive debt load. But if the company can carry this plan forward for a few years, that’s a reasonably satisfactory way to deal with the problem.
Unfortunately, for AT&T, the stock market doesn’t like long-term, boring and safe debt repayment plans. Investors are much more interested in the short-term and immediate stock moving headlines.
So, in that context, it’s not very clear which type of investor will win out. In the long term, if the company keeps its promises, those seeking years of steady dividend checks should be just fine. But for now, it’s just impossible to tell how shorter-term speculators will act regarding AT&T’s stock.
Fortunately, you don’t have to know to potentially profit here. There’s a strategy for that.
Strategy for When Only Volatility is Known
Without knowing just how investors will react in the near term to this major merger and deadly debt load, it makes no sense to go out and buy shares of AT&T or to short them. Likewise, buying either a put or a call on its own would make this more of a casino-style gamble.
There is an alternative, however. Why not both?
You see, AT&T is not known to be a very volatile player… historically. Like we noted, the company’s large dividend keeps investors mostly at bay one way or the other over long swaths of time. This summer’s Time Warner deal shook that up a bit, sending shares of the communications giant down 20% on the year. It seems, however, that AT&T’s long-term stability and low volatility is clashing with this recent run.
Options on AT&T are trading at relatively low premiums. That is usually an indication that investors don’t see much movement in the underlying company’s stock price. As we just pointed out, that is likely wrong. Investors are still struggling with which way to send T shares. And with the holiday shopping season upon us, AT&T could have even more market-moving news any day.
So, instead of picking a direction, traders could use a long straddle strategy to invest in the volatility. To enter a long straddle, a trader would purchase both a call option and a put option on the same stock, with the same strike price and the same expiration date.
It sounds counterintuitive to bet that a stock will both go up and down at the same time. Can’t happen right? Well, no it can’t. But it doesn’t have to for this trade to make money. It just has to move enough to enter positive territory for one of the two option contracts.
No matter what, one of the two options will become worthless by expiration. But if the other one doubles or triples in value, a long straddle trader is still a winner.
Here’s how this works:
Source: The Options Industry Council
As you can see, the only time this kind of trade results in a loss is if the underlying stock doesn’t move at all throughout the duration of the trade. The most a trader can lose is the amount it took to enter the trade… and only if nothing happens with the underlying shares.
The maximum profit is limitless. If shares crash, the trader profits off the put contract. If shares rally, the trader profits off the call contract.
Let’s look at a specific trade on AT&T to show this in practice.
A Specific Trade on AT&T
With shares of AT&T trading at $31, that would be an ideal strike price for this kind of strategy. And since shopping season is already upon us, a December expiration also makes a lot of sense.
So, if a trader buys a December 21 $31 call option for $0.53 per share and a December 21 $21 put option for $0.63 per share, he’d be into his long straddle trade for $1.16 per share. Since each contract represents 100 shares, that’s a total debit to his account of $116.
That’s the most the trader could lose on this trade. And it would only happen if shares of AT&T stick to $31 exactly for the next three weeks. That’s unlikely considering that just today, shares are down 3% as we write.
How much would this trader have to profit if shares don’t stay at $31? As we said above, the upside is limitless. To find just when this trade enters profit territory, however, simply take the total amount of premiums paid for both options. Then, add that to the strike price ($31 + $1.16 = $32.16). That’s the point when the trade enters positive territory if shares rally. Do the opposite to find the profit point on the downside. Take the strike price and subtract the premium paid ($31 – $1.16 = $29.84).
This movement in either direction means shares of AT&T would have to either jump by 3.7% by December 21… or fall by that amount. As we noted, just today, the company’s stock price is down 3%. That’s just in a single day. It would be completely in the realm of possibility to see it move much more than this over the coming three weeks, landing a long straddle trader with a sizable profit.
— The Option Specialist