Out-of-Favor Retailer's Comeback Could Land Traders 44% Profits
By Alan Knuckman | September 03, 2014 |

The SPDR S&P Retail ETF (NYSE: XRT) hit a 52-week high Wednesday, but the sector still has some catching up to do when compared with the broader market.

One out-of-fashion retailer that may be coming back into favor with investors is Crocs (NASDAQ: CROX). Analysts have been revising their earnings estimates higher for the past few months, and things are looking up on the chart. 

The stock has traded in a range from $12 to $18 for two years. Following a double-bottom in 2013, CROX stair-stepped in $2 increments from $14 to $16. The next stop is resistance at $18. And if shares can surpass that level, we may see a much bigger breakout rally.

CROX Stock Chart

The $18 target is about 15% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make 44% 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 CROX trading near $15.65 at the time of this writing, an in-the-money $12 strike call option currently has about $3.65 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 86.

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 recommend the CROX Mar 12 Calls at $4.50 or less. 

CROX Call Option

A close below $14 in CROX 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 $450 or less paid per option contract. The upside, on the other hand, is unlimited. And the March options give the bull trend almost seven months to develop.

This trade breaks even at $16.50 ($12 strike plus $4.50 options premium). That is less than $1 above CROX's recent price. If shares hit the $18 target, then the call option would have $6.50 of intrinsic value and deliver a gain of 44%. 

Recommended Trade Setup:

-- Buy CROX Mar 12 Calls at $4.50 or less
-- Set stop-loss at $2.25
-- Set initial price target at $8 for a potential 44% gain in seven months

Note: There's another call option strategy that lets you earn $1,200 or more each month from the stocks you already own -- by renting them out to other investors. To learn about this easy process, click here.

--Alan KnuckmanSource: Profitable Trading