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The strategy we are going to look at today has two components to it. In the first part, we sell a put. In the second part, the proceeds from the sale of the put are used to leverage your position in Alcoa (NYSE:AA). It is best to use this strategy on stocks that have pulled back strongly and are trading in the oversold ranges. Alcoa satisfies these two of these conditions. As the stock is extremely oversold (especially if one looks at the two- to three-year chart) and attempting to put in a bottom, we think there is a pretty good chance that the stock will end the year at much higher levels than its current price of $8.75.

However, as there is always the chance that things might not go as planned, we are not going to sell a naked put but instead write a bull put spread. The credit from the spread will be used to purchase calls. With a bull put spread you simultaneously sell one out-of-the-money put and purchase one put that is farther out of the money for a net credit. The long put serves as a hedge in the event things do not work out as planned. The benefit of this strategy is that your risk is defined from the onset. Your total risk is equivalent to the spread between the two strike prices. This would only occur if the stock closed at or below the lower strike price. While the downside risk is limited, the upside potential is technically unlimited as a result of the call we will purchase with the credit obtained from the spread.

Benefits of a Bull Put Spread

  1. It limits your losses if the stock suddenly plunges. Your loss is limited to the total differences between the strike prices of your short put (the put you sold) and long put (the put you purchased).
  2. The ability to profit even if the stock barely budges in price.
  3. The risk is significantly lower than writing a naked put as your maximum downside is limited by the put option you purchased. For example, if you sold a put Freeport-McMoRan (NYSE:FCX) with a strike at $40 and the stock dropped to zero, your loss would be $4,000 minus the premium you received. Now if you purchased a put with strike at $3,500, your maximum loss would be $500 minus the net premium you received. The difference is rather significant.
  4. The capital requirements are considerably less. With cash secured put you would need to have enough cash in your account to back the sale of the put. If you sold a put with a strike at $40, you would need to have $4,000 in the account. With the bull put spread, your capital requirement is limited to the spread between the two strike prices. In the above example, the spread is $500. This strategy should not be abused just because the capital requirements are significantly less. This is a conservative strategy, and by abusing it you will have converted into a speculative strategy.
  5. In the event the stock declines, an investor can buy to close the short put position and continue to lock in gains from the long put as the price of the underlying stock drops.

The Technical Outlook

Click to enlarge images.

After bottoming out toward the end of July, the stock rallied nicely from a low of $7.97 on July 24 to a high of $9.78 on Sept. 14. It has since pulled back and appears to be building momentum to trade past the $10.00 area. It has a strong level of support now in the $8.30-$8.50 range (former resistance turned into support), and this should serve as a floor to lower prices in the short to intermediate time frames. There is some resistance in the $9.00 area, which it should be able to take out in the next one to two attempts. A weekly close above $9.30 will be a very bullish development and will signal that the stock is ready to test the $10.50-$10.75 range.

Charts of Value

The orange line represents the valuation growth rate line. Generally, when the stock is trading below this line and in the shaded green area, it makes for a good long-term entry point. The stock is currently trading slightly above this line. As the stock is extremely oversold, the current setup could make for a good entry point, even though it is trading slightly above the valuation growth rate line. According to fast graphs, it has an estimated earnings growth rate of 9.2%.

When a stock is trading above the EPS consensus estimate line, it is a bullish phase and the outlook calls for higher prices. The stock is trading below the EPS line, so based on this relationship it should underperform until it manages to trade above EPS consensus line. From a contrarian perspective, one could argue that a good time to get into the stock is when the EPS experiences a trend change.

If you look at the above chart, you will notice that the EPS consensus line has started to trend upward again. So from a contrarian perspective, it might make sense to establish an early position now before the stock trades past the EPS line. Zack's consensus estimates provided below seem to indicate that earnings will improve next year.

EPS is projected to increase from $0.24 in 2012 to $0.72 in 2013 for a year over year increase of roughly 200%. As it all comes down to earnings, if these projections hold true the outlook for this stock should be pretty good going into 2013.

The Strategy

Part 1

The first part will entail the writing of a bull put spread. The credit obtained from the spread will be used to purchase calls.

The April 2013 8 puts are trading in the $0.46-$0.48 range. We will assume that the puts can be sold at $0.47 or higher.

The April 2013 6 puts are trading in the $0.08-$0.09 range. We will assume that these can be purchased at $0.09 or better. Now we will use the proceeds from the spread to purchase calls. The net credit from this spread is $38.00.

Part 2

The April 2013 10 calls are trading in the $0.30-$0.32 range. We will assume that the calls can be purchased at $0.31 or better. For each bull put spread you write, you will be able to purchase one call and have $7.00 to spare.

Transaction Details

  1. After you write the bull put spread and purchase the call, you will have a net credit of $7.00.
  2. Your maximum risk is $193.00 (the spread of $200 is subtracted from the credit of $7.00).
  3. Your maximum profit potential is unlimited due to the call purchased. Technically, there is no limit as to how high the stock could rally.
  4. Your breakeven point is $7.93.

Conclusion

The stock has taken a beating over the past two years. It appears to have bottomed out in July and is now consolidating after rallying 24% from a low of $7.97 set on July 24 to its high of $9.93 set on Sept. 14. It is now building up momentum to test its recent highs at $9.93 and challenge the $10.00 area.

FastGraphs has 9.2% growth rate for the company and Zack's has EPS estimate of $0.72, which represents an increase of 200% over the 2012 EPS estimates. These projections seem to indicate that the worst news could already be priced in, and that the stock is ready to start trending higher. The call side of the strategy provides you with the ability to lock in unlimited gains, and the bull put spread limits your total risk to $193.00.

Do not abuse this strategy, as there is always a chance that the shares could be assigned to your account. The hedge you have in place via the long put will not prevent the shares from being put into your account. Consider closing the position out if the options are showing gains in the 60%-100% range or if the stock trades to the $10.30-$10.50 range.

Options tables sourced from Yahoo Finance, option profit loss tables sourced from Poweropt.com, and EPS consensus estimates and EPS charts sourced from Zacks.com.

Disclaimer: It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies -- let the buyer beware.

Source: Alcoa - Predetermined Risk With Unlimited Profit Potential