No. 1 Drug Store Chain Could Make Traders 87% as It Plays Catch Up
“At the corner of happy and healthy,” it seems the leading U.S. drug store chains have gone their separate ways. While their products and services may be similar, their stock price action is another story.
The operator of the nation’s second largest pharmacy chain, CVS Health Corporation (NYSE: CVS), has rocketed to new all-time highs, up nearly 40% in the past 52 weeks. No. 1 Walgreen (NYSE: WAG), on the other hand, has gained only 11% during that time, lagging its competitor and the broader market.
The high degree of correlation between these two stocks became disconnected this summer. In early August, WAG got pummeled after it surprised the Street by deciding not to pursue a tax inversion in Switzerland. The stock gapped down, closing 14% lower on the day.
WAG is now in the process of playing catch up, and in the past three months, shares have gained 11% compared with CVS’ 14%.
The August gap down has been nearly filled with a price recovery. Since the big drop, WAG traded in a range from $58 to $66. An upside breakout targets an $8 move to $74, which is within striking distance of the stock’s 52-week highs.
The $74 target is about 13% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make 87% 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 WAG trading near $65.66 at the time of this writing, an in-the-money $60 strike call option currently has about $5.66 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 74.
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 WAG Apr 60 Call at $7.50 or less.
A close below $58 in WAG 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 $750 or less paid per option contract. The upside, on the other hand, is unlimited. And the April options give the bull trend more than five months to develop.
This trade breaks even at $67.50 ($60 strike plus $7.50 options premium). That is less than $2 above WAG’s recent price. If shares hit the $74 target, then the call option would have $14 of intrinsic value and deliver a gain of 87%.
Recommended Trade Setup:
— Buy WAG Apr 60 Call at $7.50 or less
— Set stop-loss at $3.75
— Set initial price target at $14 for a potential 87% gain in 5.5 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.