When a stock or ETF makes new lows in price without making new highs in volatility, this is known as a bullish divergence. It often signals the end to a sharp sell-off and is a possible sign of longer-term stability.[ad#Google Adsense 336×280-IA]That’s because the capitulation bottom is not met with the same level of fear as other declines.
The CurrencyShares Canadian Dollar Trust (NYSE: FXC) is offering a good example of this.
The latest sell-off exceeded prior lows, but volatility is nowhere near its previous highs.
The $90 level is a technical pivot and the midpoint support to watch on a weekly basis from the 2009 lows to 2011 highs.
A halfway recovery to the midpoint of the 2013 trading range targets $95 on a relief rally bounce.
The $95 target is about 6% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could more double their money on a move to that level.
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 FXC trading near $89.70 at the time of this writing, an in-the-money $85 strike call option currently has about $4.70 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 85.
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 FXC June 85 Calls at $5 or less.
A close below $85 in FXC 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 $500 or less paid per option contract. The upside, on the other hand, is unlimited. And the June options give the bull trend five months to develop.
This trade breaks even at $90 ($85 strike plus $5 options premium). That is less than $0.50 away from FXC’s recent price. If shares hit the $95 target, then the call option would have $10 of intrinsic value and deliver a gain of 100%.
Recommended Trade Setup:
— Buy CurrencyShares Canadian Dollar Trust (NYSE: FXC) June 85 Calls at $5 or less
— Set stop-loss at $2.25
— Set initial price target at $10 for a potential 100% gain in five months
Sponsored Link: By using another call option strategy, my colleague, Amber Hestla, is generating payments of $1,047, $2,435, even $3,410 (and sometimes more) from nearly any stock — even ones you already own. This free report explains everything, including names and tickers.