While equity indices were making multi-year highs, resource and commodity markets were largely left behind. The CRB Index basket of commodity prices remains 20% lower than its 2011 peak thanks to unfounded worries that global demand would come to a screeching halt. But as any contrarian trader knows, the best time to buy something is often when it is out of favor with the masses.
One stock that has seen a sharp decline is Cliffs Natural Resource (NYSE: CLF), a major supplier of iron ore. The stock fell from over $80 a share in September 2011, to a 52-week low near $32 this September, which is its lowest level since 2009.
The bullish divergence at $32 in the stock (with new lower lows in price but volatility not posting new highs) is often the sign of a significant price base. The stock is now trading above $38, and a double-digit wedge pattern sets Cliff’s Natural Resource up for a solid breakout at the $40 area. That level is also the five-year pivot that has determined the stock’s larger directional path.
Shares of Cliff’s Natural Resource have dropped more than 50% since making a 52-week high in February, and a halfway recovery bounce conservatively targets $55. That objective is about 43% above where Cliff’s Natural Resource is currently trading. That’s a large gain for shareholders, but there is a way you could potentially more than double your money with a stock substitution strategy.
One major advantage of using long call options rather than buying shares is putting up much less to control 100 shares — that’s the power ofleverage. But with all of the potential strike andexpiration 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.
Delta is a measurement of how well an option follows the movement in the underlying security. It is important to buy options that pay off from a modest price move in the stock or ETF rather than those that only make money on the infrequent price explosion.
Any trade has a 50/50 chance of success. Buying in-the-money options increases that probability. Delta also approximates the odds that the option will be in the money at expiration. 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.
For example, with Cliff’s Natural Resource trading around $38.50 at the time of this writing, an in-the-money $32 strike call currently has $6.50 in real or intrinsic value. The remainder of any premium is thetime 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.
I recommend the Cliff’s Natural Resource Jan 2013 32 Calls at $8.50 or less.
The $32 option strike gives you the right to buy below the yearly low with absolutely limited risk. A close below $32 in the stock on a weekly basis or the loss of half of the options 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 option has almost four months for the desired move to develop.
This trade breaks even at $40.50 ($32 strike plus $8.50 options premium). That is about $2 above Cliff’s Natural Resource’s current price. If shares hit the $55 price target, the option would produce a 150%-plus return on investment.
Action to Take –> Buy Cliff’s Natural Resource Jan 2013 32 Calls at $8.50 or less. Set stop-loss at $4.25. Set price target at $21.25 for a potential 150% gain in less than four months.
This article originally appearead on TradingAuthority.com:
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