Altria Group (NYSE: MO), the parent company of leading cigarette manufacturer Philip Morris USA, is a defensive stock play.
Despite sin taxes and a more negative attitude toward smoking in the United States, the company has strong brand power and could capitalize on growing emerging markets. And with a 5.3% yield, many investors buy the stock for the dividend alone.
As the chart below shows, the $30 level proved to be a breakout area for the stock’s climb higher. It is also the halfway support of the 2011 lows to the 2012 highs.
MO is down almost 8% on profit-taking since the August highs at $36 per share. With many stocks currently near their highs in a strong uptrending market, laggards are attractive, especially those that would be good long-term holdings in any market environment.
Only a weekly close below the $30 level would negate the bullish trend.
The target is about 8% above the current stock price, but there is a way you could potentially make 60% profits with a stock substitution strategy.
One major advantage of using long call options rather than buying shares is putting up much less to control 100 shares — that’s the power of leverage.
But with all of the potential strike and expiration combinations, choosing an option can be a daunting task.
Simply put, you want to buy a high-probability option that has enough time to be right, so there are two rules traders should follow:
Rule One: Choose an option with 70%-plus probability.
Delta is a measurement of how well an option follows the movement in the underlying security. It is important to buy options that pay off from a modest price move in the stock or ETF rather than those that only make money on the infrequent price explosion.
Any trade has a 50/50 chance of success. Buying in-the-money options increases that probability. Delta also approximates the odds that the option will be in the money at expiration. In-the-money options are more expensive, but they’re worth it, as your chances of success are mathematically superior to buying cheap, out-of-the-money options that rarely pay off.
For example, with MO trading around $33.25 at the time of this writing, an in-the-money $30 strike call currently has $3.25 in real or intrinsic value. The remainder of any premium is the time value of the option.
Rule Two: Buy more time until expiration than you may need — at least three to six months — for the trade to develop.
Time is an investor’s greatest asset when you have completely limited the exposure risks. Traders often do not buy enough time for the trade to achieve profitable results. Nothing is more frustrating than being right about a move only after the option has expired.
I recommend the MO Jan 2014 30 Calls at $4.25 or less.
This option strike gives you the right to buy the shares at the previous breakout level with absolutely limited risk. A close below $30 in the stock on a weekly basis or the loss of half of the option premium would trigger an exit. If you don’t use a stop, the maximum loss is still limited to the $425 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 option has a year and three months for the desired move to develop.
This trade breaks even at $34.25 ($30 strike plus $4.25 option premium). That is less than $1 above MO’s current price. If shares hit my conservative initial price target of $36, the option should gain close to 60%.
Recommended Trade Setup:
– Buy MO Jan 2014 30 Calls at $4.25 or less
– Set stop-loss at $2.13
– Set initial price target at $6.75 for a potential 59%-plus gain in 15 months
– Alan Knuckman
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