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This Fallen Brazilian Gem Could Deliver 79% Profits

Alan Knuckman

Only a few sectors have failed to participate in the broad stock market's epic run. Materials like coal, copper and other commodities have seen a 20% drop in the past year versus the 10%-plus return for the S&P 500 index during that time.

Vale SA (VALE) is a Brazil-based metals and mining company that has seen shares lose more than 50% of their value since the 2011 peak, tumbling from $34 to around $17 currently. This was partially the result of government policy changes that slowed what had been fantastic growth resurgence. But opportunity appears to be knocking once again in this South American gem.   

On the longer-term chart below, we see that the midpoint target of the five-year trading range is about $26.

VALE Stock Chart

VALE has yearly support at the bottom of the 10-month trading channel here at $17 per share. The $3 price range of that channel from $17 to $20 targets a more conservative $23 on an upside breakout.

Vale Stock Chart

The $23 target is about 34% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could almost double their money on a move to that level.

One major advantage of using long call options rather than buying the stock outright is putting up much less 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 70%-plus probability.

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.) 

Any trade has a 50/50 chance of success. Buying in-the-money options increases that probability. 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 also approximates the odds that the option will be in the money at expiration. Delta is a measurement of how well an option follows the movement in the underlying security.

With Vale stock trading at about $17.20 at the time of this writing, an in-the-money $10 strike call currently has $7.20 in real or intrinsic value. The remainder of any premium is the time value of the option.

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 VALE Jan 2015 10 Calls at $7.25 or less.

Vale Stock Options

A close below $13 in the stock on a weekly basis or the loss of half of the option premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $725 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2015 options give the bull trend almost two years to develop.

This trade breaks even at $17.25 ($10 strike plus $7.25 option premium). That is only a few cents above VALE's current price. If shares hit the upside breakout target of $23, then the call options would have $13 of intrinsic value and deliver a gain of almost 80%.

Recommended Trade Setup:

-- Buy VALE Jan 2015 10 Calls at $7.25 or less
-- Set stop-loss at $3.63
-- Set initial price target at $13 for a potential 79% gain in 22 months

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