A Short Straddle on Alcoa

Alcoa [AA:NYSE] kicks off the unofficial earnings season for the first quarter this evening, when it is prepared to announce its own Q1 results. But today, I'm not going to discuss the numbers and its estimates and forecasts. No, you can get that anywhere. Today, I'm going to quickly discuss a common trading strategy that may be employed to take advantage of the risk premium priced into stocks before an earnings report.

A short straddle is a neutral trading position in which a trader believes the stock will have a small move. Because of the higher risk and expected volatility in the stock, the option premiums will be substantially higher than it would be under normal circumstances. This strategy requires the ability to write an uncovered call and an uncovered put. In the case of Alcoa ($17.70), you could consider writing a short straddle at a strike of 18.00. The current bids on the call and put are $0.34 and $0.66 per contract respectively. That nets you $1.00 per pair of legs. Excluding commissions, the break even range on this trade is $17.00 to $19.00. That gives downside protection of 3.95% and upside protection of 7.34%. This means if the stock falls no more than 3.95% or rises less than 7.34%, you will profit. The closer it is to $18.00 by Friday, the more you earn.

But if you think the stock might move slightly lower than the current price of $17.70, then you could consider writing the 17.00 call and put. The net premiums would earn you $1.07, which would give you a break even range of $15.93 to $18.07. This strategy would profit if the stock fell less than 10.00% or rose less than 2.04%.

You must also close at least one leg on or before the expiration date. The closer it is to the strike price, the less you will have to pay to close the in-the-money option.

Disclaimer: writing uncovered (or naked) options requires substantial margin and is only available to sophisticated traders. Uncovered calls have unlimited risk and can have infinite losses. Before making any trade, always discuss this with your advisor or professional broker.