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The concern over sequestration by the federal government has pressured defense stocks in the last month. But the United States is the biggest military spender in the world, spending more each year than the other top five countries combined. This tells me there is a big picture buying opportunity in defense stocks like Raytheon Co. (NYSE: RTN).
Raytheon stock is trading about 10% below its highs from 2010 and 2012, near $60 a share. The stock's recent low around $52 is about $8 below those highs, and adding that to the highs gives us a target of $68 on a full trend recovery. The midpoint from the 2011 lows around $40 to the recent highs places strong technical support at the $50 level.
The $68 target is about 27% 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 RTN stock trading at about $53.50 at the time of this writing, an in-the-money $50 strike call currently has $3.50 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 RTN Jan 2014 50 Calls at $6 or less.
A close below $50 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 $56 ($50 strike plus $6 option premium). That is about $2.50 above RTN's current price. If shares hit the upside breakout target of $68, then the call options would have $18 of intrinsic value and deliver a gain of 200%.
Recommended Trade Setup:
-- Buy RTN Jan 2014 50 Calls at $6 or less-- Set stop-loss at $3-- Set initial price target at $18 for a potential 200% gain in one year
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