Metals are in the news, this time for a historic decline that has knocked gold and silver prices down double digits in just a few days. Out-of-favor investments often yield good returns in the long run. The basic materials sector is down more than 20% during the last 52 weeks compared with the S&P 500's 11% gain.
Dow component Alcoa (AA) is down just over 10% year to date, and as a laggard in a very strong blue-chip rally, it could be presenting an opportunity.
Since mid-2011, the stock has traded in a $3 channel between $8 and $11. It recently retreated to yearly support at $8, a base that also marks the July and November lows. A triple-bottom forming around these $8 lows could lead to a bounce from the base that pushes shares higher.
A move above the $9.50 midpoint highs of the past year could take the stock to the top of the trading range at $11.
The $11 target is about 38% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could almost double their investment 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 AA stock trading at about $8 at the time of this writing, an in-the-money $5 strike call option currently has $3 in real or intrinsic value. The remainder of any premium is the time value of the option. And this option currently has a delta of about 90.
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 AA Jan 2015 5 Calls at $3.35 or less.
A close below $6 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 $335 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2015 options give the bull trend a year and nine months to develop.
This trade breaks even at $8.35 ($5 strike plus $3.35 option premium). That is less than $0.50 above AA's current price. If shares hit the upside breakout target of $11, then the call options would have $6 of intrinsic value and deliver a gain of almost 80%.
Recommended Trade Setup:
-- Buy AA Jan 2015 5 Calls at $3.35 or less
-- Set stop-loss at $1.67
-- Set initial price target at $6 for a potential 79% gain in 21 months