Marked-Down Luxury Retailer Could Return 70%

It can be especially gratifying to purchase some of the finer things in life when they are on sale. This is true for big-ticket items like cars and televisions, or for smaller, shiny things that come in those little robin’s egg blue boxes. It can also be true for deeply discounted stocks.

As everyone knows, the high-end luxury market was hit hard in the global economic slowdown, and one stock that has seen a big decline is Tiffany & Co. (NYSE: TIF). The stock hit new 52-week lows recently at just under $50 after falling from $80 a share at the end of 2011. Currently trading around $58, the stock is sitting 28% below the yearly peak.

TIF Chart

A trading range has been established during the past two months between $50 and $58. A double-bottom has formed around $50 with bullish divergence as the stock made new lower lows but volatility did not. This is often a sign of a significant price base. A conservative target for the stock is $64, which is just 11% above where TIF is currently trading. 

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For even greater gains, TIF long call options can provide staying power in a potential larger trend extension. More importantly, the maximum risk is the premium paid for buying the option.

One major advantage of using long options rather than buying shares is putting up much less money 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. 

Simply put, 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 an option with 70%-plus probability. 

Delta is a measurement of how well an option follows the movement in the underlying security. It is important to buy options that pay off from a modest price move in the stock or ETF rather than those that only make money on the infrequent price explosion.

Any trade has a 50/50 chance of success. Buying in-the-money options increases that probability. Delta also approximates the odds that the option will be in the money at expiration. 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 ever pay off.

For example, with TIF trading around $58 at the time of this writing, an in-the-money $50 strike call currently has $8 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 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.

I recommend the TIF Jan 2013 50 Call at $10 or better. A close below $50 on a weekly basis or the loss of half of the option premium would trigger an exit.

With this trade, the maximum loss is limited to the $1,000 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2013 option has over five months for the desired move to develop.

This trade breaks even at $60 ($50 strike plus $10 option premium). That is just $2 above Tiffany’s current price. If shares simply hit the modest initial price target of $64, the option investment would produce a nearly 70% return on investment.

Recommended Trade Setup:

— Buy TIF Jan 2013 50 Call at $10 or better
— Set stop loss at $50 for TIF
— Set initial price target at $64 for TIF