This Peter Lynch-Style Pick Could Deliver 184% Returns

StreetAuthority Network

I am reminded of the old Peter Lynch axiom, "Invest in what you know," when I think about the fact that the price of a gallon of gasoline in many parts of the country is now above $4. In fact, Chicago, where I reside, now has the highest prices in the country by a large margin thanks to the switch to a more expensive summer gas blend and reduced capacity from refiners in the midst of upgrades.

The cost to fill your tank is about 50% determined by the price of crude oil and about 30% by refining costs. Crude oil has almost made a full "V" retracement back to the January, March and May peaks near $98 a barrel. A push above that level targets $105-plus, levels not seen since the spring of 2012.

A refiner play in Valero Energy Corporation (VLO) could help you take advantage of the price shock and perhaps lessen your pain at the pump.

VLO has traded in a range between $34 and $44 since January, which offers an upside breakout target of $54. Midpoint support between the 52-week high and low sits near $32.

View gallery

.
VLO Stock Chart

The $54 target is more than 40% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could almost triple 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 VLO stock trading at about $38.15 at the time of this writing, an in-the-money $32 strike call option currently has $6.15 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call 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 VLO Jan 2014 32 Calls at $7.75 or less.

Note: There are currently also non-standard VLO1 Jan 2014 32 Call option contracts that are priced above $10. Please check with your broker to make sure you are buying the standard contracts

View gallery

.
VLO Stock Call Option

A close below $32 in the stock 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 January 2014 options give the bull trend about seven months to develop.

This trade breaks even at $39.75 ($32 strike plus $7.75 options premium). That is less than $2 above VLO's current price. If shares hit the upside breakout target of $54, then the call options would have $22 of intrinsic value and deliver a gain of more than 180%.

Recommended Trade Setup:

-- Buy VLO Jan 2014 32 Calls at $7.75 or less
-- Set stop-loss at $3.87
-- Set initial price target at $22 for a potential 184% gain in seven months

For more analysis on VLO, see the video below (starting at 2:26):

View gallery

.
Alan Knuckman on VLO Video

Related Articles

View Comments (0)