The first quarter was a tough one for emerging markets, as currency scares and concerns about China’s shadow banking system spooked investors. But money is now flowing back in, and emerging markets are making a comeback in spite of the naysayers.
I think Brazil is especially attractive at the moment, as it is about to receive a lot of attention (and dollars) from the upcoming World Cup and 2016 Olympic Games.[ad#Google Adsense 336×280-IA]In particular, I like Vale S.A. (NYSE: VALE), a Brazil-based metals and mining company that has seen shares lose more than 50% of their value since the 2011 peak.
This was partially the result of government policy changes that slowed what had been a fantastic growth resurgence.
But I think the risk to reward favors the bulls in the long term.
As you can see in the chart below, VALE has long-term support at $10 to lean on.
And the decline from roughly $38 to the $12 lows puts the midpoint target around $25 in the bigger picture.
In the near term, the trading action of the past year has midpoint resistance around $14.50. If VALE can take out that resistance and its 52-week high above $17, shares could run to $22.
The $22 target is about 62% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make 200% returns 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 VALE trading near $13.60 at the time of this writing, an in-the-money $10 strike call option currently has about $3.60 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call option has a delta of about 90.
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 VALE Jan 2016 10 Calls at $4 or less.
A close below $10 in VALE 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 $400 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2016 options give the bull trend a year and nine months to develop.
This trade breaks even at $14 ($10 strike plus $4 options premium). That is less than $0.50 above VALE’s recent price. If shares hit the $22 target, then the call option would have $12 of intrinsic value and deliver a gain of 200%.
Recommended Trade Setup:
— Buy Vale S.A. (NYSE: VALE) Jan 2016 10 Calls at $4 or less
— Set stop-loss at $2
— Set initial price target at $14 for a potential 200% gain in 21 months