Bank 83% Potential Profits on This Blue Chip’s Recovery
The blue-chip Dow industrials were hit hard by the emotional selling that rocked the market in the past month. From its all-time high on Sept. 19 to its Oct. 15 low, the index gave up almost 1,500 points. It regained about half of those losses in less than a week, before giving back some of the gains in Wednesday’s sell-off.
Year to date, the Dow is flat, and more than half of its 30 components are in the red, including American Express (NYSE: AXP).
Shares of the credit card company are off 7.5% so far in 2014 and down 10% in the past three months.
The stock bounced from its lows last week after the company reported better-than-expected third-quarter earnings thanks to higher spending by its U.S. cardholders and an increase in interest income.
AXP has largely traded between $78 and $94 for the past year. A move above midpoint resistance at $86 targets a run back to the channel top.
The $94 target is about 12% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make more than 80% 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 AXP trading near $84 at the time of this writing, an in-the-money $77.50 strike call option currently has about $6.50 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 73.
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 AXP Apr 77.50 Calls at $9 or less.
A close below $78 in AXP on a weekly basis or the loss of half of the options premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $900 or less paid per option contract. The upside, on the other hand, is unlimited. And the April options give the bull trend six months to develop.
This trade breaks even at $86.50 ($77.50 strike plus $9 options premium). That is about $2.50 above AXP’s recent price. If shares hit the $94 target, then the call option would have $16.50 of intrinsic value and deliver a gain of more than 80%.
Recommended Trade Setup:
— Buy AXP Apr 77.50 Calls at $9 or less
— Set stop-loss at $4.50
— Set initial price target at $16.50 for a potential 83% gain in six months
Note: There’s another call option strategy that lets you earn $1,200 or more each month from the stocks you already own — by “renting” them out to other investors. To learn about this easy process, click here.