Low-Cost Emerging Market Play Could Almost Double Traders' Money

The energy market has been resilient as crude oil has stabilized above $100 a barrel with another recovery from recent lows. The three-year range from roughly $80 to $110 targets a move to $140 per barrel on a technical breakout above the highs.

Brazilian stocks, on the other hand, have been moving down since their 2011 peak, as emerging markets gave back some of the record gains that began in 2009. iShares MSCI Brazil Capped (NYSE: EWZ) is trading about 45% below its 2011 highs. However, a bullish divergence, with new lows in price without new highs in volatility, is signaling stabilization. 

EWZ Chart

Brazilian oil company Petrobras (NYSE: PBR) plummeted from a peak near $77 in 2008 to a low below $15. The stock saw a recovery in 2009 to around $50 before beginning its long, long downtrend.

For the past nine months, PBR has traded sideways between $18 and $12. A modest upside objective is a move to the $15 midpoint, and the combination of strength in oil prices and bargain basement prices in Brazil makes PBR a good reward-to-risk play.

PBR Stock Chart

The $15 target is about 34% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could almost double their money on a move to that level.

One major advantage of using a long call option rather than buying a stock outright is putting up much less capital 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.

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 a call option with a delta of 70 or above.

An option's strike price is the level at which the options buyer has the right to purchase the underlying stock or ETF without any obligation to do so. (In reality, you rarely convert the option into shares, but rather simply sell back the option you bought to exit the trade for a gain or loss.)  

It is important to buy options that pay off from a modest price move in the underlying stock or ETF rather than those that only make money on the infrequent price explosion. 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.

The options Greek delta approximates the odds that an option will be in the money at expiration. It is a measurement of how well an option follows the movement in the underlying security. You can find an option's delta using an options calculator, such as the one offered by the CBOE.  

With PBR trading near $11.20 at the time of this writing, an in-the-money $8 strike call option currently has about $3.20 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call option currently has a delta of about 82.

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.

With these rules in mind, I would recommend the PBR Jan 2016 8 Calls at $3.70 or less. 

PBR Call Option

A close below $10 in PBR on a weekly basis or the loss of half of the option's premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $370 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2016 options give the bull trend almost two years to develop. 

This trade breaks even at $11.70 ($8 strike plus $3.70 options premium). That is only about $0.50 away from PBR's recent price. If shares hit the $15 target, then the call option would have $7 of intrinsic value and deliver a gain of nearly 90%.

Recommended Trade Setup:

-- Buy PBR Jan 2016 8 Calls at $3.70 or less
-- Set stop-loss at $1.85
-- Set initial price target at $7 for a potential 89% gain in 22 months

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