The financial sector has been one of the strongest performers since the bear market lows of 2009.
As you can see from the chart of the Financial Select Sector SPDR (NYSE: XLF) below, the ETF traded between $10 and $18 for four years before breaking out of that range in early 2013.
The next resistance sits at $22, which is the halfway recovery point from the 2007 peak near $38 to the extreme 2009 lows near $6. But if that can be overcome, the breakout of the four-year range targets a move to $26.
The $26 target is about 31% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could make triple-digit returns on a move to that level.[ad#Google Adsense 336×280-IA]One major advantage of using long call options rather than buying a stock outright is putting up much less capital 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 a delta of 70 or above.
An option’s strike price is the level at which the options buyer has the right to purchase the underlying stock or ETF without any obligation to do so. (In reality, you rarely convert the option into shares, but rather simply sell back the option you bought to exit the trade for a gain or loss.)
It is important to buy options that pay off from a modest price move in the underlying stock or ETF rather than those that only make money on the infrequent price explosion. 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.
The options Greek delta approximates the odds that an option will be in the money at expiration. It is a measurement of how well an option follows the movement in the underlying security. You can find an option’s delta using an options calculator, such as the one offered by the CBOE.
With XLF trading at about $19.80 at the time of this writing, an in-the-money $18 strike call option currently has $1.80 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call currently has a delta of about 70.
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.
With these rules in mind, I would recommend the XLF Jan 2015 18 Calls at $2.85 or less.
A close below $18 in the stock on a weekly basis or the loss of half of the option’s premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $285 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2015 options give the bull trend about a year and seven months to develop.
This trade breaks even at $20.85 ($18 strike plus $2.85 options premium). That is a little more than $1 above XLF’s current price. If shares hit the upside breakout target of $26, then the call options would have $8 of intrinsic value and deliver a gain of more than 180%.
Recommended Trade Setup:
— Buy Financial Select Sector SPDR (NYSE: XLF) Jan 2015 18 Calls at $2.85 or less
— Set stop-loss at $1.42
— Set initial price target at $8 for a potential 181% gain in 19 months