When a sector goes through a bearish period in a bullish market, buying at key support levels for a turnaround can offer a very attractive risk/reward profile.
Take the metals and mining sector, for example. Fear of a global slowdown and commodity overproduction have pressured this group.
SPDR S&P Metals & Mining (NYSE: XME) is down 20% year to date versus a 13% gain for the broader market.
After heavy selling, copper and gold prices appear to have stabilized. And with increased volatility in runaway equity markets, metals are becoming more attractive.
XME traded in a $6 range for the past two months and is holding at the midpoint support at $37. An upside breakout targets $46, nearly 25% above current prices.
In this space, I particularly like Freeport-McMoRan Copper & Gold (NYSE: FCX) for a turnaround play. With gold prices experiencing a pullback in what is a strong, decade-long bull trend, I see significant upside potential for this miner ahead.
The stock has declined from the 2011 peak near $60 and now sits just above the $30 support level. FCX has an upside target of $45, the halfway resistance level of that decline. And the dip below the $30 pivot support and subsequent recovery is an encouraging sign of a bottom.
The $45 target is about 45% 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.
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 FCX trading at about $31 at the time of this writing, an in-the-money $25 strike call option currently has $6 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 78.
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 FCX Jan 2015 25 Calls at $7.75 or less.
A close below $27 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 $775 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 $32.75 ($25 strike plus $7.75 options premium). That is less than $2 above FCX’s current price. If shares hit the upside breakout target of $45, then the call options would have $20 of intrinsic value and deliver a gain of more than 150%.
Recommended Trade Setup:
- Buy FCX Jan 2015 25 Calls at $7.75 or less
- Set stop-loss at $3.87
- Set initial price target at $20 for a potential 158% gain in 19 months
— Alan Knuckman[ad#sa-generic]
Source: Profitable Trading