The repositioning of Xerox Corporation (NYSE: XRX) as a document management services business has helped the company and the stock stage a turnaround. XRX rallied 83% from its lows near $6 in November 2012 to its 52-week high of $11.15 on Oct. 21. Since then, XRX has pulled back a little more than 12%, providing a potentially profitable entry point.
Once a $20 stock back in 2007, XRX traded sideways between the 2009 extreme lows near $4 and the 2010 highs near $12. A breakout above the almost five-year trading range projects an $8 move to $20.
The $9 level acts as pivot support. Midpoint support of the past year’s price action is near $8.50.
The $20 target is about 104% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could see 300%-plus returns on a move to that level.[ad#Google Adsense 336×280-IA]One major advantage of using a long call option 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.
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 a call 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 XRX trading near $9.80 at the time of this writing, an in-the-money $7 strike call option currently has about $2.80 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 89.
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 XRX Jan 2015 7 Calls at $3.10 or less.
A close below $8.50 in XRX 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 $310 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2015 options give the bull trend almost 15 months to develop.
This trade breaks even at $10.10 ($7 strike plus $3.10 options premium). That is only a few cents away from XRX’s recent price. If shares hit the $20 target, then the call options would have $13 of intrinsic value and deliver a gain of more than 300%.
Recommended Trade Setup:
— Buy Xerox Corporation (NYSE: XRX) Jan 2015 7 Calls at $3.10 or less
— Set stop-loss at $1.55
— Set initial price target at $13 for a potential 319% gain in 15 months