Traders Could Book 67% Profits if They Don't Fight the BOJ

StreetAuthority Network

I believe the advice, "Don't fight the Fed," holds true no matter what language it's said in. Although in Japan, I suppose the phrase would be, "Don't fight the BOJ."

Japan's economy has been mired in what many call the "Two Lost Decades." However, new leadership at the Bank of Japan (BOJ) has announced a massive quantitative easing program that will expand Japan's monetary base by about 10% of GDP. This commitment to economic recovery by government leaders has put Japan in play for investors after years of stagnation, and it should continue pushing up stocks in this already hot global market.

One way to participate in the resurgence of the Japanese stock market is through the iShares MSCI Japan Index (EWJ). This exchange-traded fund (ETF) is a basket of large and mid-cap Japanese companies that trades like an individual stock. 

As you can see on the chart below, EWJ had been stuck in a tight trading range from about $9 to $11 since 2009. A breakout targets a minimum move to $13 per share.  

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Japan Fund EWJ Chart

The $13 target is about 16% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could see gains of almost 70% on a move to this 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 EWJ trading at about $11.25 at the time of this writing, an in-the-money $9 strike call option currently has $2.25 in real or intrinsic value. The remainder of the premium is the time value of the option. And this option currently has a delta of about 93.

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 EWJ Jan 2014 9 Calls at $2.40 or less.

A close below $9 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 $240 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend nine months to develop.

This trade breaks even at $11.40 ($9 strike plus $2.40 options premium). That is about $0.15 above EWJ's current price. If shares hit the upside breakout target of $13, then the call options would have $4 of intrinsic value and deliver a gain of almost 70%.

Recommended Trade Setup:

-- Buy EWJ Jan 2014 9 Calls at $2.40 or less
-- Set stop-loss at $1.20
-- Set initial price target at $4 for a potential 67% gain in nine months

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