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Recovery Bounce Could be Trader's Ticket to 78% Returns

The major indices have been knocking down psychological round numbers on this record run to new all-time highs. The Dow surpassed 16,000, while the S&P 500 took out 1,800. And while not a new all-time high, the Nasdaq topped 4,000 on Monday for the first time since September 2000.

Tech stocks have been in a momentous uptrend this year with the Nasdaq up more than 32% year to date.

Communications networking equipment, software and services provider Ciena (NASDAQ: CIEN) was one of the sector leaders until a pullback began in mid-October on profit-taking and general unwinding.

Nasdaq vs CIEN Stock Chart

CIEN has fallen more than 20% from its peak near $28 to midpoint support of its 52-week price action near $21. With the July and September breakout base just below at $20, risk/reward is in buyers' favor at this level. Only a weekly close below the $20 base would negate the bullish bias.

If CIEN can bounce from support, it should move back to its highs near $28. If the stock moves beyond that level, the longer-term target is $35.

CIEN Stock Chart

The $28 target is about 30% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could see a 78% return 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 CIEN trading near $21.50 at the time of this writing, an in-the-money $16 strike call option currently has about $5.50 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 83.

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 CIEN July 16 Calls at $6.75 or less.

A close below $20 in CIEN 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 $675 or less paid per option contract. The upside, on the other hand, is unlimited. And the July options give the bull trend almost eight months to develop.

This trade breaks even at $22.75 ($16 strike plus $6.75 options premium). That is about $1.25 away from CIEN's recent price. If shares hit the $28 target, then the call option would have $12 of intrinsic value and deliver a gain of almost 80%.

Recommended Trade Setup:

-- Buy CIEN July 16 Calls at $6.75 or less
-- Set stop-loss at $3.25
-- Set initial price target at $12 for a potential 78% gain in eight months

For more on CIEN, see the video below: