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One way to participate in the resurgence of the China bull trend is through the iShares FTSE China 25 Index Fund (NYSE: FXI). This ETF is made up of 25 of China's corporate leaders, and can potentially smooth out the volatility associated with the individual companies.
The China story has gone quiet during the past few years, with FXI trading in a range from $48 to $32 since 2009. Since the September 2012 low of $32, FXI has recovered with a nearly 25% bounce, placing shares just above the $40 midpoint of the trading range.
A rally to the upper end of the sideways channel gives a conservative target of $48. Longer term, a breakout targets $56 per share, which is still significantly below the 2007 highs above $70. Only a close below the $32 support level on a weekly basis would negate the bullish trend.
The $48 target is about 20% higher than current prices, but traders who use a capital preserving, stock substitution strategy could make triple-digit profits on a move to that level.
One major advantage of using long call options rather than buying the stock outright 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 FXI trading at about $40 at the time of this writing, an in-the-money $35 strike call currently has $5 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.
With these rules in mind, I would recommend the FXI Jan 2014 35 Calls at $6 or less.
A close below $32 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 $600 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend almost a year to develop.
This trade breaks even at $41 ($35 strike plus $6 option premium). That is about $1 above FXI's current price. If shares hit the upside breakout target of $48, then the call options would have $13 of intrinsic value and deliver a gain of more than 100%.
Recommended Trade Setup:
-- Buy FXI Jan 2014 35 Calls at $6 or less-- Set stop-loss at $3-- Set initial price target at $13 for a potential 117% gain in one year
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