Multiple Signs Point to a Move That Could Make Traders 112%

Goodyear Tire & Rubber Co. (NASDAQ: GT) finds itself No. 2 on Goldman Sachs’ (NYSE: GS) just released list of the 10 stocks with the greatest upside potential before they reach the firm’s price target, which in GT’s case is $19.

That alone does not support a “buy” recommendation, but the stock’s chart combined with a limited-risk strategy with time for bullish development, do.

GT stock fell from a peak at about $35 in 2007 to an extreme low near $3 in 2009. The midpoint of that move has a target of $19.

A double-bottom that has formed at $10 during the past year gives the stock a solid base. What’s more, the sideways range for 2012, from roughly $14.50 to just under $10, also projects a breakout target of $19.

GT Stock Chart

The $19 target is about 40% higher than current prices, but traders who use a capital preserving, stock substitution strategy could make triple-digit profits on a move to that level.

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One major advantage of using long call options rather than buying the stock outright 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 GT stock trading at about $13.50 at the time of this writing, an in-the-money $10 strike call currently has $3.50 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.

With these rules in mind, I would recommend the GT Jan 2014 10 Calls at $4.25 or less.

GT Stock Options

A close below $10 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 $425 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend almost a year to develop.

This trade breaks even at $14.25 ($10 strike plus $4.25 option premium). That is about $0.75 above GT’s current price. If shares hit the upside breakout target of $19, then the call options would have $9 of intrinsic value and deliver a gain of more than 100%.

Recommended Trade Setup:

— Buy GT Jan 2014 10 Calls at $4.25 or less
— Set stop-loss at $2.12
— Set initial price target at $9 for a potential 112% gain in one year