Earnings season kicks off tonight, but not into gear yet. The heavy stuff doesn't come down for a couple of weeks, although earnings season usually puts a little extra trading fodder in the trough. Whether it is helpful or not is an entirely different story.
Alcoa (AA) leads off after spending all of 2014 trying to make itself relevant again. After an impressive 50% rise in 2014, the stock did get the attention of at least a few folks. As far as earnings go, Alcoa is a throw away. It's on an island. I simply don't concern myself with Alcoa unless I'm trading Alcoa. If Alcoa sells off on good news, that's Alcoa's problem. If buyers swoop in on red and push Alcoa green, then good for Alcoa. In other words, I don't think the reaction to Alcoa is going to give us any kind of playbook for the early part of earnings season. Alcoa is an island unto itself.
If trying to play AA into earnings, I usually go with ratio call and put spreads in both directions using a 1 x 2 ratio. Therefore, if I were playing AA, I would likely be long Jan. 17 $16.50 calls and $15.50 puts, while being short twice as many Jan. 17 $17 calls and $15 puts for no net cost. Generally, I try to exit at least half of the short options soon after earnings, then look to let the spreads go for a few days, but I should note Alcoa has been a bit jumpier the past few reports.
I tend to put financials in the same boat with Alcoa. They seem to be in their own world when it comes to earnings. It is difficult to extrapolate anything from the early reports beyond how the reports and stock reactions from Wells Fargo (WFC) and JPMorgan Chase (JPM) may provide a little clue into Bank of America (BAC), Citigroup (C), Morgan Stanley (MS) and Goldman Sachs (GS).
At least with MasterCard (MA) and Visa (V) I can look at how retail is doing, in addition to some of the notes from the banks for reporting expectations, but the early reaction in WFC and JPM will likely tell us little about how technology or energy or biotech stocks will react on a miss or a beat.
Earnings are the Forest Gump box of chocolate for the market. You simply do not know what you are going to get. Don't get caught up in the hindsight from last earnings season where the one "obvious" stock priced in 10% but moved 30% on earnings. We tend to forget the five others pricing in 10% that moved only 2% or 3%.
Overall, I would look to define my risk in most, if not all, pre-earnings trades, which means something like the AA trade would be rare. Often I find it more comforting to stick a penny or two-cent option on those types of trades just to eliminate the "oh my God, I can't believe that just happened" reaction from a stock. Defining risk doesn't mean you have to define upside. Often it will slightly lessen upside potential or increase what you may need to break even, but let's face it, if you are making a trade in front of earnings, you are relying on a catalyst where few will nail it consistently. Even being correct on what you think the report will say doesn't guarantee the stock will do what you think it should do.
Over the past year, I've found the better trades, in terms of risk-reward and success, have come the day or two after the report rather than into the report. Just a few things to keep in mind as Alcoa kicks it off tonight. I am just going to be an onlooker for this report and nothing more this time around.