The bullish trend in technology stocks has reasserted itself following an April pullback. With a 14% gain so for in 2014, the Nasdaq 100 has outperformed all other major indices. And the tech index is up 28% over the past 52 weeks with new 14-year highs now almost a weekly occurrence.
Pandora Media (NYSE: P) is singing a much sadder tune, however, with shares of the streaming music provider down roughly 2% year to date. Yet, the high correlation with the tech sector is evident, as the stock is still up nearly as much as the Nasdaq 100 over the past 52 weeks despite the recent pause.
The four-month sideways action between $22 and $28 projects a $6 move to $34 on an upside breakout. The midpoint of the channel provides support at $25 to lean on.
The $34 target is about 30% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make more than 80% 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 P trading near $26.10 at the time of this writing, an in-the-money $20 strike call option currently has about $6.10 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 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 recommend the P Mar 20 Calls at $7.75 or less.
A close below $24 in P 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 March options give the bull trend more than six months to develop.
This trade breaks even at $27.75 ($20 strike plus $7.75 options premium). That is less than $2 above P's recent price. If shares hit the $34 target, then the call option would have $14 of intrinsic value and deliver a gain of more than 80%.
Recommended Trade Setup:
-- Buy P Mar 20 Calls at $7.75 or less
-- Set stop-loss at $3.87
-- Set initial price target at $14 for a potential 81% gain in six 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.
This article originally appeared on ProfitableTrading.com: Pandora's Comeback Could Be Your Ticket to 80%-Plus Profits