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Food Stock's Breakout Could Double Traders' Money by January
The global shift to more protein-rich diets has had a major impact on the food industry. Recently, a Chinese company announced its plan to buy Smithfield Foods (NYSE: SFD), the world's No. 1 pork producer, for $4.7 billion.
The impact of changing diets extends far beyond meat though. Even a moderate increase in pork, chicken and beef consumption in China and emerging markets radically alters the demand equation for the grains grown to feed livestock.
It takes 2 pounds of corn to produce 1 pound of chicken, 2.6 pounds to produce 1 pound of beef, and 3.6 pounds to produce 1 pound of pork. The value of grain commodities was evident last year when drought conditions drove prices to record highs.
One company that stands to benefit from this trend is Archer Daniels Midland Company (NYSE: ADM). It has long been called the "Supermarket to the World," and it produces protein meal, vegetable oil, corn sweeteners, flour, biodiesel, ethanol, and other value-added food and feed ingredients. It also processes oilseeds, corn, wheat, cocoa and other agricultural commodities.
ADM stock has traded between $31 and $35 for the past three months in a consolidation phase after a 30%-plus run up from the November lows. A breakout of $35 resistance targets a move to $39. Support sits at the $29 midpoint of the trading action of the past 52 weeks.
The $39 target is about 18% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could double their money on a move to that level.
One major advantage of using long call options 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.
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 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 ADM stock trading at about $33.10 at the time of this writing, an in-the-money $29 strike call option currently has $4.10 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call currently has a delta of about 77.
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 ADM Jan 2014 29 Calls at $5 or less.
A close below $28 in the stock 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 $500 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend about seven months to develop.
This trade breaks even at $34 ($29 strike plus $5 options premium). That is less than $1 above ADM's current price. If shares hit the upside breakout target of $39, then the call options would have $10 of intrinsic value and deliver a gain of 100%.
Recommended Trade Setup:
-- Buy ADM Jan 2014 29 Calls at $5 or less
-- Set stop-loss at $2.50
-- Set initial price target at $10 for a potential 100% gain in seven months
For more analysis on ADM, see the video below (starting at 2:30):