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How to Trade Alcoa Earnings Using Stock Options

Alcoa ($AA) officially kicks off earnings season with its report after the bell today.

Many investors look forward to this company's report as a general gauge on the metals sector ($XME) and a bellwether for the overall economy, although I think this belief lost its efficacy as new industries have been leading the market.

We can use the options market to get a good idea of what the market is expecting, and whether there's a trade to be had in the name.

Expiring Options

One of the benefits about the timing of $AA earnings is that options expiration is just around the corner. This makes measuring the risk in the market much more simple.

Options have two components to their price: intrinsic and extrinsic value. The intrinsic is the relationship between the stock price and the strike price, and whether the option is advantageous to exercise.

The extrinsic value is everything else, also known as the risk premium.

"Risk" generally comes in two forms: time, and volatility. Since these options have very little time left, the majority of the extrinsic value is devoted to the perceived risk of the earnings event.

And if this is all new to you, I can help.

Measured Moves

As $AA is trading at 15.80, the closest strike we have is the $16 strike. From here, we can calculate the expected percentage move by taking the cost of the straddle (call + put) and dividing it by the strike price.

The 16 straddle is going for 0.85, so 0.85 / 16 = 5.3%. In other words, the market is looking for a 5.3% move higher or lower.

That's really high, right?

Relative Performance

The perceived risk in the market should be measured in comparison to the past moves in the market.

The average 1-day movement in $AA after earnings over the past 4 quarters has been 3.45%. So it seems that the market is overpricing risk, right?

Not so fast. This calculation is only on a close to close basis, so it doesn't include intraday volatility. The average max intraday movement on the day after earnings has been 5.32%. This shows us the market is "fairly pricing" the event.

Structuring Risk

The simplest trade I see out there is a strangle sale. This is a limited reward, unlimited risk trade. Specifically, I'm looking at selling the Jul 16 call and the Jul 15 put. This is what the risk profile looks like:

The credit you can receive for this trade right now is 0.47, so that puts your breakevens by this friday between 14.53 and 16.47. These levels line up nicely with technical levels on the chart:

Do note that this trade is "naked," meaning it requries margin and has theoretically unlimited risk. To put on this trade I would recommend having some dry powder available to buy or sell stock in case the stock runs hard the day after.

 

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/