In my last article on Alcoa (AA), I was of the opinion that the bears were not finished with the stock. In that article, as I do with many of my articles, I looked for short-term income strategies to present, along with my opinion on the stock's movement.
On Alcoa, I suggested buying a July put with a strike price of '9' that was priced at $0.33. At that time, the stock was trading at 9.98, and I did not expect it to drop as far as it has so far. I was looking for support at 9.25, but to my surprise it has dropped well below the '9' level, and the option that I referred to is worth $0.71. So the play would have been nice for all who partook of it.
But now after watching the markets, I am long-term bullish on the stock and I will tell you why. Alcoa knows what needs to happen to bring prices back up to make aluminum profitable. The need for the metal has to be in direct proportion to the production. One cannot produce more than is needed; this is what brings prices down. So as it continues to travel through this rough patch and its profitability takes a beating because of falling aluminum prices, it is going to play a key role in addressing the oversupply of the commodity.
Alcoa will be a key player in bringing prices back to previous levels, as it continues to cut capacity. In April, it announced plans to cut refining capacity on the heels of closing or curtailing smelting capacity that was announced in January. This trend of capacity cuts is expected to continue in the near future until aluminum prices recover. The revival of alumina prices will be critical for Alcoa, as it derives nearly 25% value from the Alumina segment.
This is Economics 101. When supply exceeds demand, prices are bound to fall. So how does one bring prices back up? Cut the supply source until things even out. This is the first step, and since Alcoa has such a huge influence on pricing, it will not take long for things to balance out and turn around.
Now, as a long-term investor, it takes vision to see an opportunity and I believe that we have one before us. I cannot tell you the exact time of a turn around, but with the automotive industry looking at aluminum seriously as an alternative to steel for cars so that they can increase fuel efficiency, it may not be long before we see a turn up on aluminum prices as auto sales continue to pick up.
Not only this, but as Alcoa continue to plug itself into China, the company's flat rolled aluminum product will continue to pick up. The stock will turn as revenue increases. I cannot tell you when, and I do not know a good entry point, but this does open up income possibilities.
The stock is currently trading at $8.59 and we are looking at a bull call spread play far enough out to give us time decay protection as the market turns.
Click to enlarge
The Options Play
- Buy a January 2013 call with as strike of '9' (priced at $0.86)
- Sell a January 2013 call with a strike of '10' (priced at $0.49)
- Net Debit to Start: $0.37
- Maximum Profit: $0.63
Reasoning behind the Trade
- Alcoa will balance out pricing as it cuts production, and supply and demand equal out.
- The auto industry will increase demand over supply - which will help raise pricing.
