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Retailer's Rebound Could Make Traders 139% Profits

The second-quarter earnings season was a tough one for a number of retailers. However, the sector has outperformed the broader market by more than 10% year to date.

Despite falling as much as 7% from its August peak, the SPDR S&P Retail (NYSE: XRT) is up 28% for the year compared with a 17% gain in the S&P 500.

XRT vs SPX Chart

Target (NYSE: TGT) is down more than 13% from its July 24 high, partially thanks to getting caught up in traders' disappointment over Wal-Mart's (NYSE: WMT) earnings.

TGT has solid technical support near the $60 midpoint of the price action of the last two years from $47 to $73. 
 
If TGT can break through resistance at the price gap at $68, a move back to the April to August trading channel between $68 and $72 sets up a push to new all-time highs. A breakout above $72 targets a $4 run to $76.

TGT Stock Chart

The $76 target is about 19% higher than recent 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 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 TGT trading near $63.80 at the time of this writing, an in-the-money $57.50 strike call option currently has $6.30 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 77.

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 TGT April 57.50 Calls at $7.75 or less.

TGT Stock Call Options

A close below $60 in TGT 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 $775 or less paid per option contract. The upside, on the other hand, is unlimited. And the April options give the bull trend more than seven months to develop.

This trade breaks even at $65.25 ($57.50 strike plus $7.75 options premium). That is less than $1.50 above TGT's recent price. If shares hit the $76 target, then the call options would have $18.50 of intrinsic value and deliver a gain of almost 140%.

Recommended Trade Setup:

-- Buy TGT April 57.50 Calls at $7.75 or less
-- Set stop-loss at $3.87
-- Set initial price target at $18.50 for a potential 139% gain in seven months

For more analysis on TGT, see the video below:

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