Earnings season officially kicks off today with Dow component Alcoa (NYSE:AA) reporting its Q1 financial results after the bell. The aluminum behemoth has been under pressure this year along with the broader basic materials sector as most commodity-related names have largely missed the bull run of 2013. Year-to-date, AA is down 5% while the Dow Jones Industrial Average is up 11%.
Click to Enlarge While the bulls are certainly rooting for some type of earnings beat to lift the beleaguered stock, such hope in and of itself is not a valid reason to enter bullish plays before the event. Besides, Alcoa’s price action of late has been anything but inspiring.
For starters, the stock is in a short-term downtrend with declining 20- and 50-day moving averages. What’s worse, the stock has been essentially dead money, meandering aimlessly in a range between $8 and $10 since the beginning of 2012.
Earnings announcements present an interesting laboratory for volatility plays. The name of the game is to anticipate whether the options market is under- or overpricing the gap that will ensue in response to the earnings release. Historically, options overprice the move about two-thirds of the time, gifting option sellers with a profit. However, the other third of the time, options underprice the move — in many instances, they way underprice the move.
Therein lies the risk of selling options into every earnings announcement: You’ll be right most of the time, but when you’re wrong, you can be really wrong.
Click to Enlarge This go-around, the pre-earnings volatility lift in AA options appears to be a bit larger than in prior quarters. What really stands out is the large discrepancy between recent 20-day historical volatility (how volatile the stock has been over the past 20 trading days) and implied volatility (how volatile the stock is expected to be over the next 30 calendar days).
The graph in the bottom panel of the accompanying volatility chart measures the distance between HV20 and IV30. With HV 20 at 11% and IV30 at 35%, there is a +24 differential between them, which is the largest gap we’ve seen in the past two years.
If you think the volatility bid-up is overdone, you could enter a short strangle for April to exploit the expensive options. With AA currently trading around $8.35, you would sell the April 8 call and April 9 put for $1.17. The upper breakeven is $9.17 and the lower breakeven is $7.82, which means as long as AA doesn’t rise by more than 10% or fall by more than 6% by next Friday, you will capture some type of profit. The max profit of $1.17 will be locked in if AA remains between $8 and $9.
On the other hand, if you think the volatility bid-up is justified and AA is poised for a larger-than-expected gap, you could buy the aforementioned strangle (buy the April 8 call and April 9 put) for $1.17. If AA rises more than 10% or falls by more than 6% by next Friday, you’ll capture a profit. The risk is limited to the initial debit, and the reward is unlimited.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.