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Heavy equipment makers have fallen out of favor with investors as a result of the perceived slowdown in China and a drop in grain prices. Compared with the broader market's 25%-plus rally in 2013, Deere & Company (NYSE: DE) is up only fractionally for the year. At these sale prices, this American icon could make for an attractive recovery play in the new year.
DE has based out with a six-month bottoming channel between $80 and $86 since mid-June. A breakout of the trading range targets a $6 move to $92. That breakout may happen sooner rather than later, as shares are climbing after the company authorized $8 billion in new share repurchases. Only a close below the $80 support level on a weekly basis would negate the basing pattern.
The $92 target is about 8% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could see a 45% 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 DE trading near $85.50 at the time of this writing, an in-the-money $77.50 strike call option currently has about $8 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 76.
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 DE June 77.50 Calls at $10 or less.
A close below $80 in DE 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 $1,000 or less paid per option contract. The upside, on the other hand, is unlimited. And the June options give the bull trend more than six months to develop.
This trade breaks even at $87.50 ($77.50 strike plus $10 options premium). That is about $2 away from DE's recent price. If shares hit the $92 target, then the call option would have $14.50 of intrinsic value and deliver a gain of 45%.
Recommended Trade Setup:
-- Buy DE June 77.50 Calls at $10 or less-- Set stop-loss at $5-- Set initial price target at $14.50 for a potential 45% gain in 6.5 months
For more on DE, see the video below:
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