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Low volatility in one of America's favorite companies combined with the fact that it's trading at a 13% discount to its recent highs make Coca-Cola (NYSE: KO) an attractive blue-chip play.
Although the broad market S&P 500 and the technology-laden Nasdaq sit near their highs, the blue-chip Dow 30 index is lagging and needs to play catch up to keep pace. The Dow is up only 4% in the past six months versus a 9% gain in the S&P 500 and a nearly 18% jump in the Nasdaq over that same period.
KO set a new all-time high, adjusted for dividends and stock splits, just below $43.50 in May. Shares then pulled back, finding support at the two-year price pivot point at $36. This level is a critical area of technical support to watch. A close below $36 on a weekly basis would negate the bullish trend.
I see KO retaking its highs near $43.50 as blue chips play catch up. A breakout above that level sets a secondary objective at $50.
The $43.50 target is about 14% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could almost double their money 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 KO trading near $38 at the time of this writing, an in-the-money $32 strike call option currently has $6 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 91.
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 KO May 32 Calls at $6 or less.
A close below $36 in KO 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 $600 or less paid per option contract. The upside, on the other hand, is unlimited. And the May options give the bull trend seven months to develop.
This trade breaks even at $38 ($32 strike plus $6 options premium), KO's recent price. If shares hit the $43.50 target, then the call options would have $11.50 of intrinsic value and deliver a gain of more than 90%.
Recommended Trade Setup:
-- Buy KO May 32 Calls at $6 or less-- Set stop-loss at $3-- Set initial price target at $11.50 for a potential 92% gain in seven months
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