Earnings Season is Upon Us

Alcoa Aluminum (AA) starts off the earnings season tomorrow, Tuesday, after the market close. AA has had a rough year of it. It trades now for around $8 per share and its historical volatility averaged over thirty days is 130%. Aluminum smelters in the Dow aren’t supposed to trade like dot com stocks circa 2001! The implied volatility of the April options is 116% That means that there is huge uncertainty about what Alcoa will say about earnings and its future tomorrow. Again, for a Dow component that is closely followed by many analysts, this seems unusual.

How can we trade this? If we bought April 7.50 straddles, both the put and call, we would benefit from any large move that AA made on Wednesday. But what will happen to the implied volatility? Once Alcoa has its conference call, the company’s best guess about the coming quarter is out. Implied volatility will collapse and the straddle will lose value. So buying the straddle is a bet on a big move of the stock and that the implied volatility will not decrease too much.

How about selling the April straddle? Here we profit when volatility collapses, but get killed if the stock moves a lot.

What to do?

I consulted the good book, Options As A Strategic Investment (see Recommended Reading), and read the chapter on volatility trading. McMillan mentions that there is a trade that will profit from an increase in volatility. That means that we can put on the opposite trade and profit from a volatility collapse. It also has the added advantage that we can put it on for a credit, my bias, and that it will profit slightly from a big move in the stock.

Before I reveal my answer, here is the data for the options as of this morning, before the market opened. See if you find something better.

AA price: $7.93 all options have a $7.50 strike

Remember, delta is how much the call increases in value for a $1 increase in the stock price; and vega is how much the option increases in value for a 1% increase in the implied volatility of the option.
Calendar Spread

My idea is to sell a calendar spread. The usual calendar spread is to sell the April option and buy the May or July option. That profits from an increase in volatility as you can see by subtracting the vegas, 0.015 – 0.005 = 0.010 Gain a penny for every percent increase in the implied volatility. Since we are looking to profit from a drop in volatility, we do the reverse, buy the April and sell the July. We get a credit of $1.59, we make money if the volatility drops, and we have a slight profit from a large movement in the stock since the deltas are slightly different.

Looks like a good trade to me.