We're coming up on the one-year anniversary of Facebook's (FB) IPO, and it's safe to say that after the initial hype dissipated on the first trading day, investors have not necessarily "liked" the stock.
A solid price base was finally formed at $18 from August to November. By January, a nearly 80% rally from the lows took FB back to the $32 congestion level from June and July. Since then, sideways price action has found key support at the $25 midpoint of the $32 to $18 trading range. This support at a four-month low is a good area to lean on for the continuation of the bullish recovery.
A move back above $32 resistance targets a $7 bounce to $39 per share, which is below the $45 peak after the 2012 initial public offering.
The $39 target is about 54% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could more than triple that return on a move to this 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 a high probability of being profitable.
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.
With Facebook stock trading at about $25.40 at the time of this writing, an in-the-money $20 strike call option currently has $5.40 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 FB Jan 2014 20 Calls at $6.75 or less.
A close below $20 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 $675 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend almost 10 months to develop.
This trade breaks even at $26.75 ($20 strike plus $6.75 option premium). That is only a little more than $1 above FB's current price. If shares hit the upside breakout target of $39, then the call options would have $19 of intrinsic value and deliver a gain of more than 180%.
Recommended Trade Setup:
-- Buy FB Jan 2014 20 Calls at $6.75 or less
-- Set stop-loss at $3.38
-- Set initial price target at $19 for a potential 181% gain in 10 months