Ignore the Crowd – This Trade Could Double
As you can see below, the CurrencyShares Euro Trust (NYSE: FXE) fell from $134 in March to $120 in August. A recovery to the halfway point of that decline at $127 would likely send desperate short sellers running for cover. A larger objective targets a move above $130.
A move to $130 would only translate into a 4% gain for shareholders, but FXE long call options could provide you with a 100% gain while providing 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 FXE trading around $125.25 at the time of this writing, an in-the-money $120 strike call currently has $5.25 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 FXE Jan 2013 120 Calls at $6.25 or less.
A close below $120 in the stock on a weekly basis or the loss of half of the option premium would trigger an exit. If you don’t use a stop, the maximum loss is still limited to the $625 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2013 option has over four months for the desired move to develop.
This trade breaks even at $126.25 ($120 strike plus $6.25 option premium). That is less than $1 above FXE’s current price. I expect this trade to double by expiration, but ultimately you have more than four months for any bullish development with absolutely limited risk to the $625 paid for the option.
Recommended Trade Setup:
— Buy FXE Jan 2013 120 Calls at $6.25 or less
— Set stop-loss at $3.13
— Set price target at $12.50 for a potential gain of 100%