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They say that the only things certain in life are death and taxes, but I have two more virtual certainties for you: Market volatility and interest rates will increase at some point.
The compression of these components has hampered trading volume as asset markets recovered. Volatility has been reduced dramatically, meaning price moves have been smaller. Less movement has meant less trading, and therefore, a drop in exchange revenue at the CME Group (NASDAQ: CME).
The world's largest futures market company has also been negatively impacted by the Fed's zero-rate interest policy, which will eventually come to an end. The question is not if, but when. And this should cause volume to explode once Treasury futures are in play again.
A long position in CME is a hedge against the eventual rise in market volatility and interest rates.
CME shares have traded between $70 and $50 since 2009. My initial, conservative target is a move to the top of the channel at $70. Longer term, a break of the three-and-a-half-year trading range targets a run to $90.
The $70 target is about 15% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could more than quadruple those gains on a move to this 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 CME trading at about $60.80 at the time of this writing, an in-the-money $50 strike call option currently has $10.80 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 81.
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 CME Jan 2015 50 Calls at $12.25 or less.
A close below $50 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 $1,225 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2015 options give the bull trend almost a year and nine months to develop.
This trade breaks even at $62.25 ($50 strike plus $12.25 options premium). That is about $1.50 above CME's current price. If shares hit the upside breakout target of $70, then the call options would have $20 of intrinsic value and deliver a gain of more than 60%.
Recommended Trade Setup:
-- Buy CME Jan 2015 50 Calls at $12.25 or less-- Set stop-loss at $6.12-- Set initial price target at $20 for a potential 63% gain in 20.5 months
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