Small Bet on Out-of Favor Retailer Could Score Traders 146%

StreetAuthority Network

The holiday season can bring cheer to retailers that count on it to deliver a large portion of yearly sales. It's been a good year for the sector so far, with the SPDR S&P Retail ETF (XRT) outperforming the broader market with a 40%-plus year-to-date gain.

But not all retailers have shared in the prosperity. Abercrombie & Fitch (ANF), which was once a leader in the fickle world of fashion, is off 28% in the past 52 weeks. Even more striking is its underperformance in the past five years, which can be seen in the chart below.

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XRT vs ANF Stock Chart

ANF has largely traded in a range between $54 and $34 with solid support just below at $30. Bullish divergence, i.e., new lows in price without new highs in volatility, may be a sign that a bottom is forming. 

The first recovery objective is the $44 midpoint of the two-year trading range. A break above $54 projects a $20 move and a secondary target of $74.

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ANF Stock Chart

The $44 target is about 32% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could see a 146% 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. 

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With ANF trading near $33.43 at the time of this writing, an in-the-money $28 strike call option currently has about $5.43 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 80.

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 ANF May 28 Calls at $6.50 or less.

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ANF Stock Call Option

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A close below $30 in ANF 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 $650 or less paid per option contract. The upside, on the other hand, is unlimited. And the May options give the bull trend almost five months to develop.

This trade breaks even at $34.50 ($28 strike plus $6.50 options premium). That is about $1 away from ANF's recent price. If shares hit the $44 target, then the call option would have $16 of intrinsic value and deliver a gain of 146%.

Recommended Trade Setup:

-- Buy ANF May 28 Calls at $6.50 or less
-- Set stop-loss at $3.25
-- Set initial price target at $16 for a potential 146% gain in five months

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