This Alcoa (AA) Trade Could Deliver a Potential 63% Return in Less than 4 Months

money graphThis [past] week’s early selling may have sent some buyers into panic mode, but for me, it revealed one of the most interesting opportunities I’ve seen all year.

During earnings season, I typically run my earnings algorithm scan on a daily basis. My algorithm uses a multitude of inputs, including price action and analyst upgrade and downgrade percentages, and combines that data with an analysis of the options market. The algorithm targets companies most likely to beat or miss consensus estimates.

[ad#Google Adsense 336×280-IA]The most recent scan pinpointed an oversold industrial company with serious, long-term fundamental momentum. My earnings system expects it to beat estimates [this] week, which should propel shares higher in the short term.

The company is the world’s largest aluminum manufacturer, Alcoa (NYSE: AA). It is scheduled to report earnings on Wednesday, Oct. 8, after the close.

It has beaten estimates in three of the past quarters, exceeding them by an average of 83% (and 54% if you count the losing quarter).

I expect Alcoa to continue to surpass estimates and for the entire sector to do well for the foreseeable future.

Big Bets on Aerospace

Alcoa is aggressively pushing into aerospace, a $120 billion a year industry in the United States alone. It just opened the world’s largest aluminum-lithium plant, a $90 million, 170-acre manufacturing facility that is one of three planned factory expansions aimed at servicing the booming industry. And the timing seems more than opportune.

Boeing (NYSE: BA) announced Thursday that it would up its production of 737 jetliners from 42 a month to a record 52 a month beginning in 2018. Boeing and its biggest competitor, Airbus, project that global demand for single-aisle aircraft will be between 22,000 and 26,000 over the next 20 years as aging fleets are replaced and airlines in emerging markets expand.

That’s great news for the company that will be the largest supplier of lightweight aluminum-lithium alloys used to make more fuel-efficient, lower-cost aircraft. Alcoa’s alloys are already being used to make fuselage skins, wing stringers, floor beams, seat tracks and other components.

The company also signed a $1.1 billion supply agreement with Pratt & Whitney to develop the first ever aluminum-lithium forging for a front fan blade for the aerospace manufacturer’s PurePower engines. And in June, it announced a $2.85 billion deal to buy jet engine part maker Firth Rixson.

Alcoa’s edge comes from its quality, design technology and patents, not to mention the fact that these new plants and methods will be able to produce aluminum-lithium ingots that are approximately 50% larger than the nearest competitor.

The aerospace industry is notorious for its backlogs, which number in the thousands and could take almost a decade to fill at current production rates. This bodes very well for Alcoa’s future growth and stability.

And let’s not forget about the other businesses this aluminum pioneer supplies, including consumer electronics, food and beverage packaging, oil and gas drilling, power generation and the automotive industry. For example, the metal for Ford’s (NYSE: F) new aluminum-built F-150 pickup truck will come from Alcoa, with deliveries of the vehicle scheduled for 2015.

The majority of analysts have been raising their estimates heading into Alcoa’s third-quarter earnings report, scheduled for Wednesday. My earnings algorithm shows a high probability of the company beating estimates, which should help drive shares higher.

The technicals also support the near-term bullish outlook.

AA broke to a 52-week high of $17.36 on Sept. 4, and then succumbed to selling. The stock now appears to be bouncing from oversold levels, as evidenced by the Relative Strength Index (RSI) at the bottom of the chart. This indicator has turned up from an oversold reading of 30, which makes this an opportune entry point.

I see AA eclipsing the recent high of $17.36 and moving to $17.68, which is just over $2 above current prices.

The target is derived from the 10-day moving average of the daily Average True Range (ATR). ATR is a measure of volatility that helps us visualize the “normal” amount a stock travels in a day. I frequently see stocks move one to two times their daily ATR after a break above a 52-week high.

The $17.68 target is about 13% above current prices, but we can leverage that move into 60%-plus profits with a call option strategy.

AA Call Option Trade

Today, I am interested in buying AA Jan 13 Calls for a limit price of $2.88.

AA Call Option

This call option has a delta of 87, which means it will move roughly $0.87 for every dollar that AA moves, but it costs only a fraction of the price of the stock.

The trade breaks even on expiration at $15.88 ($13 strike price plus $2.88 options premium), which is 2% above current prices.

If AA hits my $17.68 target, then the call option will be worth at least $4.68 for a 63% return. Place a good ’till cancelled (GTC) order to sell the calls at this price.

Recommended Trade Setup:

— Buy Alcoa (NYSE: AA) Jan 13 Call at $2.88 or less (use limit orders)
— Set stop-loss at $1.20
— Set price target at $4.68 for a potential 63% profit in less than four months

Jared Levy


Source: Profitable Trading