This Trade could Turn $2,000 into $8,000 by September
The financial sector has led the way in 2012 with gains of nearly 20%, double the S&P 500’s performance. The boys in Banking know how to make easy money with no end in sight. With interest rates all but guaranteed to remain at record lows, basically free money, the cash machine will be busy spitting out money for these institutions.
My favorite way to trade financials is through the Financial Select Sector SPDR (NYSE: XLF) ETF. Half of XLF’s top ten holdings are bank stocks, including Bank of America, Wells Fargo and JP Morgan Chase. These three banks, which make up more than 20% of XLF’s valuation, reported upbeat earnings last week.
XLF is up 35% in a few short months from the $11.50 base formed in December. The question now is how to profit from this sector’s strength while limiting risk on any pullback.
And there’s plenty of upside potential. Just a halfway retrenchment from the 2009 lows to the 2007 highs targets an objective at $22, a 40% gain if you bought shares at current prices.
An aggressive investor could buy shares and place an exit order on any brake below the established trend line at $15. All too often, however, a short-term fluctuation forces out positions before then moving in the desired direction.#-ad_banner-#
There’s a better way to trade XLF. A long call option can provide the staying power in a potential larger trend extension. More importantly, the maximum risk is the premium paid for buying the option.
The Options Way: Unlimited Upside Potential with Limited Risk
One major advantage of using long options instead of buying or selling shares is putting up much less money to controll 100 shares — that’s what makes them extremely leveraged.
Choosing an option can sometimes be a daunting task with all of the choices and expirations. Simply put, traders want to buy a high probability option that has enough time to be right.
The option strike price is the level at which you have the right to buy without any obligation to do so. In reality, you rarely convert the option into shares. Simply sell the option you bought to exit the trade.
There are two rules options traders need to follow to be successful.
Rule One: Choose an option with 70%-plus probability. The Delta is a measurement of how well the option reacts to movement in the underlying security. It is important to buy options that payoff from only a modest price move. There is no need to only make money on the all but infrequent price explosion.
Any trade has a fifty/fifty chance of success. Buying options ITM options increase that probability. That Delta also approximates the odds that the option will be In The Money at expiration. Buying better options are more expensive, but they are worth it — the chances of success are mathematically superior to buying cheap, long shot Out Of The Money lottery tickets that rarely ever pay off.
With XLF trading at $15.50, for example, an In The Money $14 strike option currently has $1.50 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 buy too little time for the trade to develop. Nothing is more frustrating than being right but only after the option has expired premature to the market move.
Trade Setup: I recommend the September XLF $14 Call at $2.00 or less. A close below $14 on a weekly basis or the loss of half of the option premium would trigger and exit.
Looking at the XLF chart above, the $14 level has been a price pivot for the last year. This area also coincides with the important 50% retracement support from the current rally run. The September option gives the bull trend five months to develop.
The maximum loss is limited to the $200 paid per option contract. The upside, on the other hand, is unlimited.
The trade breaks even if XLF is trading at $16 at expiration ($14 strike plus $2 the premium = $16). That’s just $0.50 above XLF’s current price. If shares hit my $22 price target, the option would be worth $8 plus time value, a gain of at least 300%.