Sometimes the most profitable investments are made by going against the grain — selling when everyone else is buying and buying when everyone else seems to be selling.
Take PR nightmare Lululemon Athletica (NASDAQ: LULU) for example. The stock is off more than 50% from last summer’s highs above $80 on declining sales, competition worries, product recalls, and of course, a big-mouthed CEO (recently former CEO) whose excuse for product defects was “some women’s bodies just don’t work” for its yoga pants.[ad#Google Adsense 336×280-IA]Yet LULU is still the top-selling manufacturer of fashionable activewear, according to retail analyst Jeff Green.
And on the chart, we saw a bullish divergence, with a new 52-week low made on June 13 without new highs in volatility.
This can be a technical sign that a bottom has been put in place in a formerly freefalling stock.
At this point, I’d say the risk/reward favors the bulls.
While five-year midpoint support at $40 has been violated, LULU has traded in a range from $35 to $45 for the past three and a half months. An upside breakout of this range targets a move to $55.
The $55 target is about 42% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could 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 LULU trading near $38.75 at the time of this writing, an in-the-money $25 strike call option currently has about $13.75 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 95.
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 recommend the LULU Jan 25 Calls at $15 or less.
A close below $30 in LULU 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 $1,500 or less paid per option contract. The upside, on the other hand, is unlimited. And the January options give the bull trend five months to develop.
This trade breaks even at $40 ($25 strike plus $15 options premium). That is less than $1.25 above LULU’s recent price. If shares hit the $55 target, then the call option would have $30 of intrinsic value and deliver a gain of 100%.
Recommended Trade Setup:
— Buy Lululemon Athletica (NASDAQ: LULU) Jan 25 Calls at $15 or less
— Set stop-loss at $7.50
— Set initial price target at $30 for a potential 100% gain in five months
Source: Profitable Trading