Options Strategies Prior to Alcoa Earnings

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Alcoa
AA
will report earnings Monday after the closing bell. Consensus estimates for the quarter are that revenue will be $5.8 billion and earnings per share will be $0.06. In the previous quarter, Alcoa had revenue of $6 billion and earnings per share of $0.09. Investors can use options to bet how far the stock price will change as a result of the earnings announcement. A volatility crush is when an option goes from a period of high implied volatility to a period of low implied volatility. After an event (such as an earnings announcement) implied volatility decreases causing options to decrease in value. Traders should expect the value of Alcoa options to decrease after earnings are announced because of a volatility crush. Alcoa is currently trading at $8.66 a share. Using a forward volatility formula, an implied earnings move can be calculated. The implied volatility of a straddle for the weekly options is 51%. Straddles with further expirations have lower implied volatilities. For example, the implied volatility for a straddle expiring on Jul 21st is 42.5%. Using the implied volatility of at the money straddles with weekly July expiration and July expiration on the third Friday of this month. Investors are pricing in an implied event move of roughly 4.47%. Therefore, investors believe that Alcoa's earnings announcement will cause shares to appreciate or depreciate by roughly 4.47%. In essence, this is the move priced into Alcoa options. Investors who predict that Alcoa earnings will cause the stock to move by more than 4.47% should purchase the weekly options. By purchasing call and put options, investors can implement either a long strangle or long straddle strategy. These strategies are long volatility. A strangle can be formed by purchasing a put option with a strike price of $8 and a call option with a strike price of $9. The net debit on the transaction using current option prices is $0.19. The breakeven points are $7.81 and $9.19. For the strangle to be profitable, Alcoa shares must be valued less than $7.81 a share or greater than $9.19 a share at expiration. A straddle can be formed by purchasing both a put and a call expiring this week with a strike price of $9. The net debit on this transaction using current option prices is $0.63. The breakeven points are $8.37 and $9.63. For the straddle to be profitable, Alcoa shares must be valued less than $8.37 a share or greater than $9.63 a share at expiration. Since the strategy has different breakeven points, investors should have a directional view going into earnings. Investors who expect Alcoa to beat earnings would be better off implementing the strangle since the upper breakeven point is $9.19. Investors who expect Alcoa to miss earnings would be better off implementing the straddle since the lower breakeven point is $8.37. These strategies are profitable if the event move exceeds roughly 4.47%. Investors who believe Alcoa will report revenue and earnings in line with analyst expectations would expect Alcoa shares to trade relatively close to current levels. Investors would then expect Alcoa shares to appreciate or depreciate less than the implied earnings move of 4.47%. Investors who believe earnings will be in line with analyst expectations could take the other side of the option trades described above. Investors taking the other side of the trade would be implementing either a short strangle or a short straddle. The breakeven points would be the same except investors want the price of Alcoa shares to remain within the breakeven points.
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Posted In: EarningsLong IdeasNewsShort IdeasFuturesOptionsIntraday UpdateAfter-Hours CenterMarketsMoversTrading Ideas
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