LIGHT METAL FIGHT FOR FLIGHT
Another old industrial, former DOW component, Alcoa has had a tough couple of years. This latest down slide has AA off 36% in over the last year to the DOW plus double digits.
The $20 drop over the last 52 weeks puts the recovery midpoint pivot at $27.50.
AA has traded from $18 to $22 over the last weeks targeting $26 on an upside breakout.
An AA long call options can provide the staying power in a potential larger trend extension. More importantly, the maximum risk is the premium paid for buying the option.
The Options Way: Unlimited Upside Potential with Limited Risk
One major advantage of using long options instead of buying or selling shares is putting up much less money to control 100 shares — that’s the power of leverage.
Choosing an option can sometimes be a daunting task with all of the choices and expiration months. Simply put, traders want to buy a high probability option that has enough time to be right.
The option strike price is the level at which you have the right to buy without any obligation to do so. In reality, you rarely convert the option into shares. Simply sell the option you bought to exit the trade for gain or loss.
There are two rules options traders need to follow to be successful.
Rule One: Choose an option with 70%-plus probability. The Delta is a measurement of how well the option reacts to movement in the underlying security. It is important to buy options that payoff from only a modest price move. There is no need to ONLY make money on the all but infrequent price explosion.
Any trade has a fifty/fifty chance of success. Buying options ITM options increase that probability. That Delta also approximates the odds that the option will be In The Money at expiration. Buying better options are more expensive, but they are worth it — the chances of success are mathematically superior to buying cheap, long shot Out Of The Money lottery tickets that rarely ever pay off.
With AA trading at $21.50, for example, an In The Money $17 strike option currently has $4.50 in real or intrinsic value. The remainder of any premium is the time value of the option.
Rule Two: Buy more time until expiration than you may need — Time is an investor’s greatest asset when you have completely limited the exposure risks.
Traders often buy too little time for the trade to develop. Nothing is more frustrating than being right but only after the option has expired premature to the market move.
Trade Setup: I recommend the April AA $17 Call at $5.50 or better. A close below $17 on a weekly basis or the loss of half of the option premium could trigger an exit.
Looking at the AA, the $17 is just above the annual low not seen since January of 2016. This In The Money option gives you the right to buy at discounted price.
The April option has six months for bullish development.
The maximum loss is limited to the $550 or less paid per option contract. A stop loss exit will be placed at half of the premium paid to limit exposure.
The upside, on the other hand, is unlimited. The In The Money option has a delta of 80% so it will behave much like the stock for a fraction of the cost of owning the shares.
The trade breaks even is at $22.50 or above at expiration ($17 strike plus $5.50 or less option premium). Alcoa was at that level just 6 weeks ago.