Double Your Money While Everyone is Looking the Other Way

 The banking sector has remained out of the news as overall market volatility dropped, falling to five-year lows last week. The decrease in fear is not only very bullish, but also makes a stock substitution strategy more powerful.

The financial sector has held its ground and quietly recovered against the backdrop of never-ending euro zone fears. The Financial Select Sector SPDR (NYSE: XLF) is up 14% year to date and is less than a dollar away from its 52-week high

Turning to an individual bank, Morgan Stanley (NYSE: MS) has made a solid double-bottom at $12 with bullish divergence on the last dip to support. A 10-week trading channel from $12 to $15 sets up a run to $18 on a range breakout. That technical objective is nearly 22% higher than the present stock level.

MS Chart

Twenty-two percent is a respectable enough return, but a stock substitution play using a long call option limits the cost and the overall trade risk while maximizing the profit potential.

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.

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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 MS trading around $14.80 at the time of this writing, an in-the-money $12 strike option currently has $2.80 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 April 2013 MS 12 Call at $3.75 or less. A close in the stock below $12 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 $375 or less paid per option contract. The upside, on the other hand, is unlimited. And the April 2013 option has eight months for the desired move to develop.

This trade breaks even at $15.75 ($12 strike plus $3.75 option premium). That is less than $1 above Morgan Stanley’s current price. If shares break out of the wide sideways channel, the option should approach a doubling of the original premium. 

Best of all, this option play has staying power with the ability to ride through ups and downs that would force most stock traders out of their positions.

Recommended Trade Setup:

— Buy MS April 2013 12 Call at $3.75 or better
— Set stop-loss at $12 for MS
— Set initial price target at $18 for MS