AT&T (T) got spanked at the end of last week and this came after the stock was already down more than 7% from its September high.  By Friday, the stock was down more than 15% from that recent high, but then it found support.  This might only be a dead cat bounce, but I think the worst might be over for T, as the dividend yield (5.40% forward yield) should provide support around the current price.  If it doesn’t, the yield will only improve.

Since I’m not overly confident in this prediction or the market as a whole in the near-term, I decided not to sell straight out naked puts on T; instead, I went with a put spread close to the money.  While T was trading at $34.25, I sold four T January $34 puts for $1.11 and bought four T January $32 puts for $0.46.  I received $253.79 after paying $6.21 in commissions for the $0.65 spread.  This is a twist on my usual trades.  Typically, I sell a higher quantity of put spreads farther out of the money or naked puts close to the money.  I plan to take the assignment on these T puts if the stock finishes expiration below $34.00 and that’s why I only sold four combinations.  I’m really looking at this trade as four puts, just with lower risk and return.  Since there’s so much unknown right now with the fiscal cliff in play, I thought it wise to hedge in case of an all out meltdown after January 1st (if not before).

If I take the option assignment in January, I’ll need $13,600 available to buy the shares.  Considering that I just took in $253.79, I stand to make 1.9% (10.3% annualized) on the money I have at risk ($13,346.21).  However, my real money at risk (due to the long puts hedging my position) is only $546.21.  That means that I could make a 46.46% return (20.8% monthly).  The probability is too close to even to expect a trade like this to work out much more than half the time (T can only dip 3.00% before I shift to a paper loss), but by hedging, I can open more exposure without fearing some black swan event that really hurts me.  Looking at both sides of how this could work, I have a 4.09% limit to my losses from the $13,346.21 backing the puts.

I’m not quite ready for this next step yet, but it’s something I’m considering once conditions turn more favorable.  If I ran my entire account on trades like this and was willing to take up to 8% in losses, I could target a 15% annualized return.  That’d be using twice my account value to fund the trades and would expect at least 5% in losses.  If I really thought conditions were better, I could have a wider spread on the trades. Right now, it’s not much more than a passing thought, but is more likely to remain just another piece of my overall strategy mixed in with the other strategies I am already using.  The hole in actually implementing this for my entire account is that the loss limit of 8% comes six times per year.  That means I could lose a lot more than 8% over a full 12 months.

For anyone else who likes this trade and thinks it’s attractive for your account, T has fallen some more since my order hit and the bid/ask has increased a few cents.  Keep in mind, T could fall even more if investors start fleeing dividend payers based on the belief that the tax rate on dividends is going to go up.  Even if it does, I still believe receiving dividends is good for an account.

My next trade could be a bigger hedge.  I’ve thought about buying out of the money call spreads or selling in the money put spreads on SH, the S&P 500 inverse ETF.  The SPX looks weak right now and a little inverse exposure would soften the blow of any downfall to come.  I might couple a trade like this with a non-option bullish trade.  I’m planning on waiting for a resolution or decent patch to the fiscal cliff, but could implement it sooner.  When I see a good opportunity, I’m planning to buy shares of SSO and immediately including a trailing stop to limit my losses if I’m wrong in my bullish sentiment.  If I have an inverse ETF option trade in place at the same time, I could pay for the SSO risk.  We’ll see – I’m still working on it.