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Retailer's Bounce Back Could Land Traders 86% Profits

Believe it or not, retail has been one of the strongest sectors in the past year. The numbers don't lie. SPDR S&P Retail (XRT) is up over 30% in the past 52 weeks compared to a 20% rise in the S&P 500 index.

In the past five years, well-known apparel retailer The Gap (GPS) has more than tripled the broader market's performance, rallying more than 250% to its August high.

Shares broke down last week on a surprise 3% drop in September same-store sales, the company's worst performance in almost two years. They now sit just below $38 pivot support.

Once Gap fills the gap at $38, look for a move back into the five-month trading range between $40 and $46. The $43 midpoint of that range is our target.

GPS Stock Chart

The $43 target is about 16% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make 86% profits on a move to that level.

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. 

With GPS trading near $37 at the time of this writing, an in-the-money $32 strike call option currently has $5 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 GPS March 32 Calls at $5.90 or less.

ABX Call Option

A close below $30 in GPS 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 $590 or less paid per option contract. The upside, on the other hand, is unlimited. And the March options give the bull trend more than five months to develop.

This trade breaks even at $37.90 ($32 strike plus $5 options premium). That is about $1 above GPS' recent price. If shares hit the $43 target, then the call options would have $11 of intrinsic value and deliver a gain of 86%.

Recommended Trade Setup:

-- Buy GPS March 32 Calls at $5.90 or less
-- Set stop-loss at $2.95
-- Set initial price target at $11 for a potential 86% gain in five months

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