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The airline industry has seen a recovery in profitability and share prices. U.S. airlines are expected to lead the recovery in the global sector's profits this year, according to the International Air Transport Association (IATA). And the Amex Airline Index (NYSE: XAL) has ran from about $35 in September to above $55 in March, a near 60% rally.
Southwest Airlines (NYSE: LUV), one of soon to be four major airlines in the United States (after the merger of US Airways and American Airlines), looks poised for a breakout after trading in a range between $14 and $8 for the past three years.
Currently trading just above $13, a move above $14 targets a $6 run (the height of the trading channel) to $20 per share. LUV peaked just below this level in 2003.
The $20 target is about 53% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could more almost triple their investment 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 Southwest stock trading at about $13.10 at the time of this writing, an in-the-money $10 strike call option currently has $3.10 in real or intrinsic value. The remainder of any premium is the time value of the option. And this option currently has a delta of 90.
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 LUV Jan 2014 10 Calls at $3.50 or less.
A close below $10 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 $350 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend about nine months to develop.
This trade breaks even at $13.50. ($10 strike plus $3.50 option premium). That is less than $1 above LUV's current price. If shares hit the upside breakout target of $20, then the call options would have $10 of intrinsic value and deliver a gain of more than 180%.
Recommended Trade Setup:
-- Buy LUV Jan 2014 10 Calls at $3.50 or less-- Set stop-loss at $1.75-- Set initial price target at $10 for a potential 186% gain in nine months
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