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Thursday, November 1, 2012 - 06:00
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Thursday, November 1, 2012 - 06:00
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Thursday, November 1, 2012 - 06:00

This Buffett Holding Could Make Traders 111%

Thursday, November 01, 2012 6:00 AM

Some investors think if it's good enough for Warren Buffett, then it's good enough for them. And he likes banking giant Well Fargo (NYSE: WFC). The stock has traded in a sideways range largely between $32 and $36 for the past eight months. The initial upside objective on a channel breakout rally is $40. Only a weekly close below the $30 support level would negate the bullish trend.

The $40 target is nearly 18% higher than current prices, but traders could use a stock substitution strategy to make 100%-plus returns on a move to this level. One major advantage of using long calloptions 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 WFC trading around $34 at the time of this writing, an in-the-money $30 strike call currently has $4 in real or intrinsic value. The remainder of any premium is thetime 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 WFC April 30 Calls at $4.75 or less.

A close below $30 in the stock on a weekly basis or the loss of half of the option premium would trigger an exit. If you don't use a stop, the maximum loss is still limited to the $475 or less paid per option contract. The upside, on the other hand, is unlimited. And the April option gives the bull trend nearly six months to develop.

This trade breaks even at $34.75 ($30 strike plus $4.75 option premium). That is less than $1 above WFC's current price. If shares hit the $40 price target, then the option would more than double.

Action to Take --> Buy WFC April 30 Calls at $4.75 or less. Set stop-loss at $2.38. Set initial price target at $10 for a potential 111%-plus gain in six months.

This article originally appeared on TradingAuthority.com:

This Buffett Holding Could Make Traders 111%

Alan Knuckman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.