Rare Sale on a High-End Stock Could Land Traders 100% Profits
Higher-end retailers have flourished as the wealth effect of a rebound in housing and equities has freed up funds for spending. The price performance of Macy’s (NYSE: M) and Tiffany & Co. (NYSE: TIF) compared to discounters like Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) illustrates this trend.
High-end grocery chain Whole Foods Market (NASDAQ: WFM) is on pace with the S&P 500 this year, gaining about 23%. The stock is currently offering a rare sale. In the past three months, WFM is down 3% while the S&P 500 is up 5%. And it is off 15% from its all-time high of $65.59, made in October.
The $50 level is an important pivot, serving as resistance in 2012 and support in the second half of 2013. The first target is a retracement to the $66 high.
The $66 target is about 18% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could see a 100% 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 WFM trading near $55.85 at the time of this writing, an in-the-money $50 strike call option currently has about $5.85 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 75.
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 WFM May 50 Calls at $8 or less.
A close below $50 in WFM 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 $800 or less paid per option contract. The upside, on the other hand, is unlimited. And the May options give the bull trend five months to develop.
This trade breaks even at $58 ($50 strike plus $8 options premium). That is less than $2.50 away from WFM’s recent price. If shares hit the $66 target, then the call option would have $16 of intrinsic value and deliver a gain of 100%.
Recommended Trade Setup:
— Buy WFM May 50 Calls at $8 or less
— Set stop-loss at $4
— Set initial price target at $16 for a potential 100% gain in five months