The Financial Select Sector SPDR (NYSE: XLF) offers a diversified way to invest in the banking sector. The fund's top 10 holdings include Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFX) and JPMorgan Chase (NYSE: JPM), which make up more than 20% of its valuation.
There is plenty of upside potential for the banking exchange-traded fund (ETF). A halfway retracement to the 2007 highs from the 2009 lows targets an objective of $22, a 41% gain from current levels. A nearly year-long trading range between $14 and $16 has seen volatility decline to 52-week lows in a bullish sign of an impending move, and offers a more conservative first breakout target of $18. Only a close below the $14 support level on a weekly basis would negate the bullish trend.
The $18 target is 15% higher than current prices, but traders who use a stock substitution strategy could make close to 70% returns on a move to that level.
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 of leverage. But with all of the potential strike and expiration 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 XLF trading at about $15.65 at the time of this writing, an in-the-money $13 strike call currently has $2.65 in real or intrinsic value. The remainder of any premium is the time 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 XLF June 13 Calls at $3 or less.
A close below $14 in XLF on a weekly basis or the loss of half of the option premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $3,000 or less paid per option contract. The upside, on the other hand, is unlimited. And the June options give the bull trend seven months to develop.
This trade breaks even at $16 ($12 strike plus $3 option premium). That is less than $1 above XLF's current price. If shares hit the conservative breakout target of $18, then the option would deliver a gain of almost 70%.
Action to Take --> Buy XLF June 13 Calls at $3 or less. Set stop-loss at $1.50. Set initial price target at $5 for a potential 67% gain in seven months.
This article originally appeared on TradingAuthority.com
A Bet on the Financials Could Bank You 67% Profits