This Exxon (XOM) Trade Could Make You a Potential 80% Return in 7 Months

The latest unrest in the Middle East caused a spike in oil, which had already established itself above $100 a barrel for two months prior. But it’s more than temporary geopolitical tensions that are driving energy prices higher.

The trend is unquestionably bullish with an 18% year-to-date gain in the Energy Select Sector SPDR (NYSE: XLE), which is trading at its highest level since its 2008 record peak.

Multinational oil and gas corporation Exxon Mobil (NYSE: XOM) has lagged the sector with only a 3% gain in 2013.

XOM has formed a strong yearly support base at $86, and the risk/reward favors the bulls. The sideways action from $92 to $86 targets a $6 move on an upside breakout to $98 per share.

The $98 target is about 10% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make 80% profits 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 XOM trading near $88.84 at the time of this writing, an in-the-money $80 strike call option currently has $8.84 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call option currently has a delta of about 82.

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 XOM April 80 Calls at $10 or less.

A close below $80 in XOM 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 $1,000 or less paid per option contract. The upside, on the other hand, is unlimited. And the April options give the bull trend more than seven months to develop.

This trade breaks even at $90 ($80 strike plus $10 options premium). That is a little more than $1 above XOM’s recent price. If shares hit the $98 target, then the call options would have $18 of intrinsic value and deliver a gain of 80%.

Recommended Trade Setup:

— Buy Exxon Mobil (NYSE: XOM) April 80 Calls at $10 or less
— Set stop-loss at $5
— Set initial price target at $18 for a potential 80% gain in seven months

Alan Knuckman

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Source: ProfitableTrading