While the major indices have seen double-digit percentage gains this year, including a 15% rise in the Dow Jones Industrial Average, the metals and mining sector has been left in the dust.
But this lagging sector may have bottomed out and could now present a bullish opportunity to make up lost ground. One stock in particular, former Dow component United States Steel Corp. (NYSE:X), has caught my eye. Its underperformance so far in 2013 is glaring, with the stock down about 28%.
X has traded in a $4 range since the break below $20 this spring. We have seen a double-bottom at $16 support with lows in April and July.
The stock appears to have stabilized right above the $18 midpoint of its trading range, which suggests a push to the top of the channel. A breakout above the $20 level targets $24.
The $24 target is about 33% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could more than double their money 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 X trading at about $18 at the time of this writing, an in-the-money $16 strike call option currently has $2 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 70.
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 X April 16 Calls at $3.75 or less.
A close below $16 in X 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 $375 or less paid per option contract. The upside, on the other hand, is unlimited. And the April options give the bull trend eight months to develop.
This trade breaks even at $19.75 ($16 strike plus $3.75 options premium). That is less than $2 above X's current price. If shares hit the $24 target, then the call options would have $8 of intrinsic value and deliver a gain of more than 100%.
Recommended Trade Setup:
-- Buy X April 16 Calls at $3.75 or less
-- Set stop-loss at $1.87
-- Set initial price target at $8 for a potential 113% gain in eight months
For more analysis on X, see the video below (starting at 2:24):