Traders Could Nail Down 67% Profits in This Out-of-Favor Market

Contagion is not only a concern from a global health standpoint, but from a financial one as well. Economic weakness in the euro zone and Russia’s muscle flexing have taken their toll on Europe’s strongest economy, Germany. Its government just reduced its 2014 growth forecast to 1.3% from 1.5%.

Global markets rallied very much in tandem from the financial crisis lows to multiyear highs this summer. But since peaking in June, Germany’s DAX index fell nearly 17% to its mid-October lows. 

For contrarian investors, this looks like the perfect opportunity to “buy when there’s blood in the streets.”

Prior to the recent sell-off, iShares MSCI Germany (NYSE: EWG) had nearly double since its October 2011 lows. And the rally in U.S. equities in the past week demonstrates how quickly out-of-favor markets can recover.

Midpoint support of EWG’s five-year trading range sits below at $24.50. This is a key level to lean on, and the reward/risk looks to favor the bulls at current prices.  

If shares can move back above $28.50, which would mark a 50% retracement of the June-to-mid-October correction, the next target would be a full “V” recovery to the $32 highs. Only a close below $24.50 support on a weekly basis would negate the bullish premise.

EWG Stock Chart

The $32 target is about 19% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make 67% 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 EWG trading near $26.95 at the time of this writing, an in-the-money $22 strike call option currently has about $4.95 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 84.

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 EWG Jan 2016 22 Call at $6 or less. 

EWG Call Option

A close below $24.50 in EWG 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 $600 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 $28 ($22 strike plus $6 options premium). That is just over $1 above EWG’s recent price. If shares hit the $32 target, then the call option would have $10 of intrinsic value and deliver a gain of 67%. 

Recommended Trade Setup:

— Buy EWG Jan 2016 22 Call at $6 or less
— Set stop-loss at $3
— Set initial price target at $21 for a potential 67% gain in 15 months