The bull market run in 2014 has not treated all equally. While the broad market S&P 500 is up 6.5% for the year, the Dow industrials have only eked out a 1.7% gain. If the bull continues its charge into 2015, the blue chips are likely to play catch up.
One of the components that has held the Dow back is Wal-Mart Stores (NYSE: WMT), which is down almost 5% year to date.
WMT has been largely bound by a range between $72 and $80 for the past year and a half. The stock is currently trading above solid support at $72, and I believe the risk/reward favors the bulls at these levels. An upside breakout through $80 resistance targets an $8 move to $88.
The $88 target is about 18% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make more than 140% on a move to that level.
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 WMT trading near $74.80 at the time of this writing, an in-the-money $67.50 strike call option currently has about $7.30 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 89.
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 WMT Mar 67.50 Calls at $8.50 or less.
A close below $70 in WMT 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 $850 or less paid per option contract. The upside, on the other hand, is unlimited. And the March options give the bull trend almost eight months to develop.
This trade breaks even at $76 ($67.50 strike plus $8.50 options premium). That is less than $1.50 above WMT's recent price. If shares hit the $88 target, then the call option would have $20.50 of intrinsic value and deliver a gain of more than 140%.
Recommended Trade Setup:
-- Buy WMT Mar 67.50 Calls at $8.50 or less
-- Set stop-loss at $4.25
-- Set initial price target at $20.50 for a potential 141% gain in eight months
--Alan KnuckmanSource: ProfitableTrading