Writing on July 3rd. Happy Independence Day and welcome back to the Daily Swim. As I wrote about before, earnings season will soon be upon us with July 8th marking the beginning of the season and the announcement of Alcoa (AA) earnings. Hopefully, you have been tracking the front month implied volatility since my last post when July volatility was trading 52%. As I noted before, implied volatility tends to increase as the earnings date approaches. If we look at the July volatility as of July 3rd, AA front month volatility is now trading 64% with five days to go until earnings. So, what does this mean to you as traders and how can you make money off of the move in volatility?

One strategy that I like to implement when trading single stock volatility in products such as Alcoa (AA) is to buy the nearest back month options, in this case August, about one week before the earnings announcement. Even though this strategy will result in paying decay and add some delta risk, for that one week, the amount of decay is usually minimal as the implied volatility increases. Remember, volatility is uncertainty. Uncertainty about Alcoa's earnings will keep the implied volatility inflated, as we can see from the 12% increase over the past month. Once I now own the August options, I wait until the day before earnings to sell the corresponding strike in the front month, July, to take advantage of the difference in implied volatilities between the two months. In essence, I have legged myself into a calendar spread while working for better execution by waiting until the July premium is fully inflated. This usually occurs the day before or the day of earnings. You can make this a directional play by choosing the call or put calendar. For instance, if you believe Alcoa stock will sell off after the earnings announcement, then the put calendar would be a better play. In our case, for Alcoa, the July/August 30 put calendar would represent a bearish bias. I prefer to place my earnings calendars at the at-the-money strike if I do not have a bearish or bullish bias. Just remember that calendars are short gamma positions, so large moves in the underlying are detrimental to the value of the calendar.

In order to see how far Alcoa can move in our at-the-money calendar example to capture a profit, I have created a simulated trade using the thinkorswim Analyze Tab. As you can see, the calendar, as of July 3rd, would cost about $88 per one lot. In my example, I have chosen to buy five calendars for a total debit of $440. Now as we move closer to the earnings date, we could leg into the calendar to reduce that cost. Our maximum profit occurs if the stock settles at $32.50, however, we continue to make money as long as Alcoa stays between our Break Even points of $30.20 and $35.22. If you believe that this will be the case, then this might be a strategy to consider.

Let's keep an eye on Alcoa to see how it performs over the next week. Until then, best of luck trading.

Joe Mazzola

thinkorswim, Inc. and its registered employee, Joe Mazzola, do not solicit or recommend any form of trading in the individual stocks (or their derivatives) mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. The risk of loss may be substantial.