Relief Rally in This $10 Stock Could Double Traders’ Money

Energy prices have plummeted across the board in recent months. West Texas Intermediate (WTI) crude has fallen to its lowest level since June 2012, while natural gas is trading near 11-month lows. 

Coal has been especially hard hit over the past few years thanks to the increasing supply of cheap natural gas and environmental concerns.

A Republican takeover in Congress could help end the coal shaming and give prices a boost. Elections, like markets, are difficult to predict, but after the drawn-out decline in the sector, the downside risk appears limited.

Prior to the recent selling, Market Vectors Coal ETF (NYSE: KOL) traded between $20 and $17 for most of the past year. Importantly, the new lows made earlier this month did not come with new highs in volatility. This is known as a bullish divergence and is often a sign that sellers have been exhausted and a bottom is in place.

KOL Stock Chart

Peabody Energy (NYSE: BTU) is the largest private-sector coal company in the world. It suffered a string of losses and has fallen from its $74 peak in 2011 to under $10 on Monday. 

This is the first time prices have been below $10 in a decade. A relief rally is in order, and a friendlier political climate could spur higher prices. 

In the past year, BTU established a trading range from $20 to $14. If shares can move back into that range, the first target is the midpoint resistance of the channel at $17.

BTU Stock Chart

The $17 target is about 70% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could more than double their money on a move to that level.

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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 BTU trading near $10 at the time of this writing, an in-the-money $5 strike call option currently has about $5 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 93.

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 BTU Jan 2016 5 Call at $5.75 or less. 

BTU Call Option

A close below $8 in BTU 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 $575 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2016 options give the bull trend over a year to develop.

This trade breaks even at $10.75 ($5 strike plus $5.75 options premium). That is less than $1 above BTU’s recent price. If shares hit the $17 target, then the call option would have $12 of intrinsic value and deliver a gain of more than 100%. 

Recommended Trade Setup:

— Buy BTU Jan 2016 5 Call at $5.75 or less
— Set stop-loss at $2.87
— Set initial price target at $12 for a potential 109% gain in 15 months