Breakout Could Score Traders 162% Profits by Mid-2013
The Energy Select Sector SPDR’s (NYSE: XLE) chart shows a six-month technical wedge pattern from $61 to $77 with higher lows and lower highs, and gives traders an initial bullish breakout target of $85. The five-year chart of the energy ETF shows the same pattern with 2007 highs and a target of $90. Only a close below the $68 support level on a weekly basis would negate the bullish trend.
The $85 target is more than 20% higher than current prices, but traders who use a stock substitution strategy could make triple-digit returns on a move to that level.
One major advantage of using long call options rather than buying shares is putting up much less 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 70%-plus probability.
Delta is a measurement of how well an option follows the movement in the underlying security. It is important to buy options that pay off from a modest price move in the stock or ETF rather than those that only make money on the infrequent price explosion.
Any trade has a 50/50 chance of success. Buying in-the-money options increases that probability. Delta also approximates the odds that the option will be in the money at expiration. 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.
For example, with XLE trading at about $70.65 at the time of this writing, an in-the-money $66 strike call currently has $4.65 in real or intrinsic value. The remainder of any premium is the time value of the option.
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.
I recommend the XLE June 66 Calls at $7.25 or less.
A close below $68 in the stock on a weekly basis or the loss of half of the option premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $725 or less paid per option contract. The upside, on the other hand, is unlimited. And the June options give the bull trend more than six months to develop.
This trade breaks even at $73.25 ($66 strike plus $7.25 option premium). That is a little more than $2.50 above XLE’s current price. If shares hit the upside breakout target of $85, then the option would deliver a gain of more than 160%.
Recommended Trade Setup:
— Buy XLE June 66 Calls at $7.25 or less
— Set stop-loss at $3.63
— Set initial price target at $19 for a potential 162% gain in six months