It seems like nothing is ever on sale at high-end natural grocer Whole Foods Market (Nasdaq: WFM) -- but what is on sale is the company's stock.
Trading near $40 at the start of 2006, WFM plunged to the single digits in 2008, as investors questioned customers' ability to pay premium prices for groceries. Emerging from the depths of the financial crisis, WFM's trajectory was nearly straight up until peaking at its all-time high above $65 in October.
The $40 level is an important pivot point, as it represents the midpoint of the price action from the past five years. When WFM pushed above this level in 2012, it became support.
An earnings miss in early May sent shares cratering almost 20% in one day. Since then, WFM has traded sideways between $37 and $43. The first target for a price recovery is a retracement to the top of the trading range and the middle of the May gap down, near $44.
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The $44 target is about 17% higher than recent prices, but traders who use a capital-preserving stock substitution strategy could make 70% 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 1: 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 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 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.
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The option's 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 $37.65 at the time of this writing, an in-the-money $32.50 strike call option currently has about $5.15 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call option has a delta of about 78.
Rule 2: 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 recommend the WFM Jan 32.5 Calls at $6.75 or less.
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A close below $34 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 $675 or less paid per option contract. The upside, on the other hand, is unlimited. And the January options give the bull trend six months to develop.
This trade breaks even at $39.25 ($32.50 strike plus $6.75 options premium). That is about $1.60 above WFM's recent price. If shares hit the $44 target, then the call option would have $11.50 of intrinsic value and deliver a gain of 70%.
Action to Take -->
-- Buy WFM Jan 32.5 Calls at $6.75 or less
-- Set stop-loss at $3.35
-- Set initial price target at $11.50 for a potential 70% gain in six months
This article was originally published at ProfitableTrading.com:
Grocery Chain's Super Sale Could Result in 70% Profits by 2015