Make a Potential 30% or 100% on This Drilling Stock… Your Choice

Natural gas and oil driller Chesapeake Energy (NYSE: CHK) is setting up for a move higher. The stock has formed a base at $14, and a series of higher lows on a climb to the year-long technical pivot at $20 sets up a potential breakout run. The wedge pattern seen on the chart below gives us a target of $26, which is the 2012 high made in March. 

CHK Chart

A move to $26 would give shareholders a 30% return, but there is a way you could double your money with a stock substitution strategy. Continued low volatility makes a call option purchase attractive for long-term positioning. 

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 pay off.

For example, with CHK trading around $20 at the time of this writing, an in-the-money $16 strike call currently has $4 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 CHK April 2013 16 Calls at $5.25 or less.

CHK Options Chart

A close below $16 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 $525 or less paid per option contract. The upside, on the other hand, is unlimited. And the April 2013 option has seven months for the desired move to develop.

This trade breaks even at $21.25 ($16 strike plus $5.25 option premium). That is just a little more than $1 above CHK’s current price. If shares rally back to the March highs at $26, the option should double.

Recommended Trade Setup:

— Buy CHK April 2013 16 Calls at $5.25 or less
— Set stop-loss at $2.62
— Set price target at $10.50 for a potential 100% gain in seven months