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Pounce on Homebuilders' Sell-off Now for Potential 65% Returns

Alan Knuckman

Homebuilders, as measured by the SPDR S&P Homebuilders ETF (XHB), gained 68% in the past 52 weeks, hitting a recent high of $32.69 on May 22. Since then, unwinding, profit-taking and broader market weakness led to a drop of about 14% to important support at $28.

Since last summer's breakout above $22, XHB has taken an interesting stair-step approach, moving up in roughly $2 increments and consolidating in between. The $22 level is also the midpoint support of the 2011 low at $12 to the recent $32 highs. A move back above those highs targets a run to $36.

XHB Chart

The $36 target is about 24% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could more than double those returns 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 XHB trading at about $29 at the time of this writing, an in-the-money $22 strike call option currently has $7 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 84.

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 XHB Jan 2015 22 Calls at $8.50 or less.

A close below $22 in XHB 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 $850 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2015 options give the bull trend about a year and seven months to develop.

This trade breaks even at $30.50 ($22 strike plus $8.50 options premium). That is only about $1.50 above XHB's current price. If shares hit my breakout target of $36, then the call options would have $14 of intrinsic value and deliver a gain of 65%.

Recommended Trade Setup:

-- Buy XHB Jan 2015 22 Calls at $8.50 or less
-- Set stop-loss at $4.25
-- Set initial price target at $14 for a potential 65% gain in 19 months

For more analysis on XHB, see the video below (starting at 2:30):

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