Tariffs Will Hurt This Company
Often, there’s a story that plays out over the course of an earnings season. While many traders focus on the numbers reported by the companies, others dig deeper and listen to what management is talking about in conference calls with analysts.
During the calls, managers will expand on the numbers in the financial statements. They will also take questions from analysts and could reveal additional information in their answers. While the calls will still be general in nature, the topics covered can provide valuable insights to analysts.
This quarter, the topic to watch is tariffs. And, already the news has been troubling for some companies.
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Alcoa Cautions On Tariffs
Alcoa Corp. (NYSE: AA) fell sharply after the aluminum company cut its outlook, citing the unfavorable impact of aluminum tariffs and increased energy costs.
Chief Executive Roy Harvey said on the post-earnings conference call that tariffs on imported aluminum has only resulted in a “limited increase” in U.S.-based supply, so imports will remain essential to satisfy demand, according to a transcript provided by FactSet.
The immediate response from analysts added to the bearish news. Analyst Michael Gambardella at J.P. Morgan reiterated his overweight rating but cut his stock price target to $80 from $86. On Wall Street, estimates and target prices will generally carry more weight than ratings like “overweight.”
Traders sold heavily on the news.
But the stock was already in a down trend that began after the company’s previous earnings report in April disappointed investors. Analysts have been steadily downgrading the stock since then.
The chart below shows the average broker recommendation on a scale from 1 to 5. Alcoa has long been considered a laggard by Wall Street analysts with a consensus rating that is below average.
The stock is now likely to continue in that down trend as analysts lower their ratings even more in the coming days. It’s now likely that AA will struggle until the company is able to deliver good news, which may not come until the trade war is resolved. But, that might not be enough.
Alcoa also noted that higher energy prices hurt profits. Even if the trade war rhetoric eases, energy prices are unlikely to fall much according to many analysts. Tension in Iran and supply issues, for now, seem to be providing a floor to oil and that is unlikely to be resolved in the near term.
That indicates traders should consider strategies that can benefit from weakness in the stock. In the long run, the company could turn around but a short term rebound seems unlikely. That makes short term strategies appealing.
A Trading Strategy To Benefit From Weakness
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook for the short term, a call option should be sold.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.
A Bear Call Spread in AA
For AA, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell an August 17 $43 call for about $0.95 and buy an August 17 $44 call for about $0.65. This trade generates a credit of $0.30, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $30. The credit received when the trade is opened, $30 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $70. The risk is found by subtracting the difference in the strike prices ($100 or $1.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($30).
This trade offers a potential return of about 43% of the amount risked for a holding period that is about three weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if AA is below $43 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $70 for this trade in AA.
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