It’s “show me the money” time once again for the financials. JPMorgan Chase (NYSE: JPM) and Wells Fargo (NYSE: WFC) will kick off earnings season for the group this week. With interest rates still near record lows, I expect the sector’s strong performance to continue.
The Financial Select Sector SPDR (NYSE: XLF) is up 23% in the past 52 weeks, but another of the Big Four banks has not kept pace. Citigroup (NYSE: C) has gained only 8% during that time.
C essentially traded sideways for the past year between $ 54 and $ 46 per share. It is now trading at the bottom of that range, just above $ 46 support. The initial target is a return to the top of the channel at $ 54.
Midpoint support from the 2012 $ 25 lows to the 2014 highs near $ 55 sits at $ 40. Only a close below $ 42 on a weekly basis would negate the bullish trend.
The $ 54 target is about 16% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make five times as much 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 C trading near $ 46.54 at the time of this writing, an in-the-money $ 40 strike call option currently has about $ 6.54 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call option 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 C Sept 40 Calls at $ 7.75 or less.
The $ 40 strike price is at the midpoint of the 2012 to 2014 trading action. A close below $ 42 in C 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 $ 775 or less paid per option contract. The upside, on the other hand, is unlimited. And the September options give the bull trend five and a half months to develop.
This trade breaks even at $ 47.75 ($ 40 strike plus $ 7.75 options premium). That is only a little more than $ 1 above C’s recent price. If shares hit the conservative $ 54 target, then the call option would have $ 14 of intrinsic value and deliver a gain of more than 80%.
Recommended Trade Setup:
– Buy C Sept 40 Calls at $ 7.75 or less
– Set stop-loss at $ 3.87
– Set initial price target at $ 14 for a potential 81% gain in 5.5 months
Note: Most online options brokerage accounts have an advanced feature that lets you take and keep money lost in the stock market, essentially claiming it before Wall Street brokers get their hands on it. Here’s how you could use it to get away with $ 1,200 or more today.
