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Buyers Could Increase Their Returns Fivefold With This Trade
Intel (NASDAQ: INTC) shares declined sharply from the May 2012 highs above $29, falling below $20 by the end of the year. However, a base has formed and the stock has rebounded back above the five-year pivot point at $20.
The midpoint of last year's high to the year's extreme low near $19 puts the next resistance target at $24. The bullish divergence in volatility at the stock's low is another positive.
The pullback in Intel stock that began a little more than a week ago is an opportunity to use the power of options.
The $24 target is about 14% higher than current prices, but traders who use a capital preserving, stock substitution strategy could make more than five times that amount on a move to that level.
One major advantage of using long call options rather than buying shares is putting up much less 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 pay off.
For example, with Intel stock trading at about $21 at the time of this writing, an in-the-money $18 strike call currently has $3 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 INTC Jan 2014 18 Calls at $3.50 or less.
A close below $20 in the stock on a weekly basis or the loss of half of the option premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $350 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend about a year to develop.
This trade breaks even at $21.50 ($18 strike plus $3.50 option premium). That is about $0.50 above INTC's current price. If shares hit the modest upside breakout target of $24, then the call options would deliver a gain of more than 70%.
Recommended Trade Setup:
-- Buy INTC Jan 2014 18 Calls at $3.50 or less
-- Set stop-loss at $1.75
-- Set initial price target at $6 for a potential 71% gain in 12 months