Anyone that has been long Frontier Communications (NYSE:FTR) since the start of the year has experienced a lot of volatility. It began the year at $5.15 with a dividend of $0.75 per share, a yield of 14.6% and management telling shareholders the dividend was secure. The market was telling management that it didn't believe the dividend was secure, as was clearly evident from a yield in the mid-teens. Unfortunately for this author, who was only beginning to doubt management and ignoring the market's wisdom, the market proved to be correct.
The market often follows the adage, "Buy on the rumor, sell on the news." When the anticipated news is bad, often the opposite will occur. In anticipation of a dividend cut the stock drifted down, dropping below $4 on two occasions in the early part of the year. On Monday, February 13th, the shares opened at $4.08. On Friday, February 17th, the day after the dividend cut from $0.75 to $0.40 was announced, the shares closed at $4.78, up 17% from the Monday opening price.
The stock has taken investors on a wild ride. The price had fallen to $3.06 on May 8th and actually reached the $5.15 price where it began the year on September 28th. On more than one occasion the price of the shares moved 10% in a single day. And although the shares have not risen above $5.15, the volatility has presented nimble traders with an opportunity to make a lot of money. It has also made trading in options very profitable.
The Frontier Dividend And Taxes
Frontier's dividend can be unusual. Much of it has been classified as return of capital. This means that instead of it all being reported as ordinary dividend income, a portion of it is used to reduce an investor's cost basis. Eventually, when the stock is sold, the investor uses the reduced cost basis to determine the gain or loss.
In recent years, dividends and capital gains have both had very low tax rates. As we head towards the much talked about fiscal cliff, no one is quite sure how this income will be treated. Will ordinary dividends be taxed at a higher rate next year? What about capital gains? Will a potential change only apply to the rich or will it apply to everyone? Should one sell a position with a large capital gain to take a advantage of the low rates? Should one sell dividend paying stocks since the dividends may be taxed at a higher rate next year? This uncertainty has been one of the reasons given for the recent weakness in stock prices.
And, it's not just the dividends and capital gains. It's also the top tax rates. Wealthy individuals with large gains. or executives with significant gains in restricted stock units and incentive stock options, could become motivated sellers as the end of the year approaches.
Most of the trades discussed below avoided some of these tax issues because they took place in tax advantaged Roth IRA accounts. However, to the extent that the tax backdrop has an impact on share prices, there could be still be an impact.
Conservative Option Strategies
I am not daring enough to make successful naked option trades and find the time decay of the premium too risky. However, I have been trading covered calls for nearly as long as I have been trading stocks, and this past year I have written several articles about how covered calls can create significant yield opportunities while affording increased safety on an investment in Frontier.
When discussing the dividend yield on November 28, 2011 I wrote:
"Can an investor mitigate the impact of a potential dividend cut?" Using options or LEAPs, and taking the risk of losing out on capital appreciation, an investor can reduce their exposure. Currently, Frontier is trading at $5.39. January 2013 LEAPs with a strike price of $5 are trading at $0.75 bid. Buynig [sic] the stock and selling the LEAP will cost a net of $4.64 (excluding commissions).
How has this strategy worked? An investor would have received one $0.1875 dividend and three $0.10 dividends so far for a total of $0.4875. With Frontier having closed the week at $4.29, and if one includes the dividends, the investor would be up slightly on their net cost of $4.64. A straight long position, on the other hand, would be down $1.10, offset by the same $0.4875 in dividends and be in the hole $0.61 at this point. It's a difference between a 3% gain and a loss of 11%. And, both parties are likely to get another $0.10 dividend next month.
One month later, the strategy was again recommended as a top income idea for 2012. The shares were then trading at $4.95, and even with the dividend cut, the yield has been better than 8%. I also noted this about the call strategy:
The strategy still works (and, at the moment it is even better), although it may not be necessary to sell in the money calls. Currently the shares are trading at $4.95 and the $5 January 2013 call can be sold for $0.45. The net (excluding commissions) is $4.50 per share. If the shares are called, you make 11%. If you collect dividends, your yield is even higher.
At this point, it does not appear that the shares will be called, and the $0.40 dividend is providing a yield on net cost of 9%. If the shares are not called in January, the investor will get another chance to sell a call option, enhancing their return. All of which brings me to the point of this article.
Stocks with high dividend yields, like Frontier, tend to reflect the market's lack of faith in the sustainability of that dividend. Stocks, like Frontier, that have high volatility, often have high premiums on their options. These factors can provide an investor looking for income the opportunity to lower their net cash outlay, while simultaneously reducing some of the risk and increasing the yield. The downside (other than another dividend cut) is that the investor may be sacrificing some potential capital appreciation.
During the past year I have made several trades with Frontier, including the one recommended above. On December 7th, I wrote:
In the interest of full disclosure, I'd like to let everyone know that I do drink my own Kool-Aid. Although I missed out on the outstanding opportunity in the article because of the sharp upward move in share price on the Monday after publication, I still opened a new position in FTR this morning. I missed the December dividend but I made a small purchase using the in-the-money covered call strategy I bought 1100 shares at $5.31 and simultaneously sold the $5 January 2013 LEAP for $0.75 for a net cost of $5032.31 (including all commissions and fees) or $4.575 per share.
It wasn't the best timing, having lost the December dividend, and the overall position including the dividends is barely above breakeven. However, in January there will either be the opportunity to sell another covered call or the price of the stock will have recovered to $5 and the shares will be called away.
The idea has worked much better throughout 2012. On February 11th I wrote the following comment:
I bought more today (Friday 2-10) in 2 separate trades in two separate accounts using the type of in the money (or at the money) covered call trades discussed in the article. In both cases I bought FTR and sold $4 March calls. First transaction was at 10:56 when I bought 1100 shares at $4.06 and sold the calls for $0.30 - a net price of $3.775 per share after commissions. The second took place at 13:32 when I bought at $4.02 and sold the calls at $0.31 - a net price of $3.726 per share after commissions.
It is a strategy where I am expecting that these shares will be called before the stock goes ex-dividend in early March. If it happens as I expect, and estimating the commissions and fees on the sales, the returns would be:
$3.99 / $3.775 = 5.7%
$3.99 / $3.726 = 7.1%
Not too bad for less than a month. If they don't get called, I will be happy to get the dividend and sell additional calls.
And, in a subsequent comment on March 7th:
In the interest of disclosure, and largely because I have been told that my trading strategies are very complex (I never thought of them that way), I wanted to let everyone know that both of these trades have now been called, This was entirely expected as it made sense that someone would want to get the dividend.
The surprise was that the first trade was called last week. The second of the two covered call transactions was closed today nearer the ex-div date (the trade involving 900 shares and 9 $4 March 2012 call). Now if I only had another safe, conservative play where I can get 6-7% in less than a month... ;-(
In another comment on March 14th:
I just followed my strategy by placing a combination order to buy the stock and sell the $4 AUG calls at a net debit of $3.82. It was for 1200 shares and 12 calls. The shares were purchased at $4.27 and the calls were sold for $0.45. I expect that the shares will continue to trade above $4 and that they will be called away when the stock goes ex dividend in early June. If not, I will be satisfied with ten cent quarterly dividends until it is called away in August. Either way the annualized yield would be in the high teens.
Since the stock traded below $4 around the ex-dividend date, the call was not exercised until the August option expiration. The total return was $0.28 comprised of the $0.18 gain on the net cost and one $0.10 dividend. The return on the investment was:
.28/3.82 = 7.3%
in 5 months, and resulted in an annualized yield of more than 17%.
The funds received when the second February 10th trade was called were used on March 19th to buy shares of Frontier at $4.26 and sell $4 November calls for $0.45, resulting in a net cost of $3.81. These were called this past Friday, and since there were two dividends during the period yield was even better. The total return was $0.39 comprised of the $0.19 gain on the net cost and two $0.10 dividends. The return on the investment was:
.39/3.81 = 10.2%
in 8 months, and resulted in an annualized yield of more than 15%.
Current Option Strategies Available
An investor looking to take advantage of using covered calls has a few different alternatives for Frontier. Using the $4.29 closing price of the stock on Friday, November 16th, the options that I find most attractive are the $4 and $4.50 strike prices for January 2014. These are trading $0.50 Bid/$0.65 Asked and $0.30 Bid/$0.40 Asked, respectively.
The shares of Frontier go ex-dividend on December 4th, so it is possible that executing an in the money $4 option trade could result in the shares being called at any time. And, as long as the shares are trading above $4.00 14 months from now, one can be assured that the shares will be called at expiration. So, why would it be attractive to buy the shares at $4.29 only to sell them for $4.00 no later than January of 2014? The option premium of $0.50 reduces the net cash outlay to $3.79/per share. Selling at $4 any time thereafter would be a gain of 5.5%. And, because the $0.40 dividend is now being paid on a $3.79 cost, the dividend yield on cost is 10.6%.
Buying the stock and selling the $4.50 January 2014 call for $0.30 is a somewhat more aggressive alternative. The initial cash outlay would be $3.99 and the yield on cost would be 10.0%. The big advantage is that if the price does rise back to $4.50, the gain on the net cash outlay would be $0.51 on $3.99 net cost, or 12.8%.
Recently David Klein wrote an article about the safety of the Frontier dividend. My view is that the dividend is safe, at least through January 2014, the term of the option strategies recommended. However, there are always risks. There is the potential for another credit event or interest rates rising or taxes rising, or a political stand-off in Washington, any of which could make Frontier and its dividend less attractive. Or, one only needs to look at the destruction that can be caused by weather events like Irene or Sandy and the impact on Frontier's infrastructure. Or macro issues like the sovereign debt crisis in Europe or the military actions in the MidEast or...
I find the risk acceptable and it is currently my intention to open a new position using the $4.50 covered calls sometime this week by placing a combination limit order, simplifying the process and reducing the commissions on the transaction.
Disclosure: I have covered calls written against some of my Frontier positions, and may open a new position at any time. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.