Coal Play Could More Than Double Your Money in a Year’s Time

The chart of the Energy Select Sector SPDR (NYSE: XLE) reflects the uptrend in energy prices. The ETF is now within striking distance of its 2008 peak above $91. The 2010-2012 trading range between $60 and $80 projects a technical objective of $100, which sits about 17% above recent prices.

XLE Chart

Peabody Energy (NYSE: BTU) is a coal company that has seen major volatility over the past few years. It rallied from below $16 in 2008 to above $70 in 2011, and then back down to a $14 low this past summer.

A wide trading range from $20 to $14 has been established during the past six-plus months. The breakout target is $26 ($6 height of the trading range added to $20 resistance). Support at the $17 midpoint of the range puts the reward to risk heavily in favor of the bulls at these levels.

BTU Stock Chart

The $26 target is about 50% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could see a 100%-plus return on a move to that level.

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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 BTU trading near $17.35 at the time of this writing, an in-the-money $13 strike call option currently has about $4.35 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 81.

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 BTU Jan 2015 13 Calls at $5.75 or less.

A close below $16 in BTU 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 $575 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2015 options give the bull trend a year to develop.

This trade breaks even at $18.75 ($13 strike plus $5.75 options premium). That is only about $1.50 away from BTU’s recent price. If shares hit the $26 target, then the call option would have $13 of intrinsic value and deliver a gain of more than 100%.

Recommended Trade Setup:

— Buy BTU Jan 2015 13 Calls at $5.75 or less
— Set stop-loss at $2.87
— Set initial price target at $13 for a potential 126% gain in one year