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Thursday, July 10, 2014 - 15:30
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Thursday, July 10, 2014 - 15:30

Catch-Up Rally Could Mean 47% Gains With This Lagging Blue-Chip Stock

Friday, July 11, 2014 7:00 AM

While the blue-chip Dow Jones Industrial Average is up 11% over the past 52 weeks, it has some serious catching up to do with the broader S&P 500 Index, which has gained 19% during that time.

Of the Dow 30 components, nearly a third are in negative territory for the year. Verizon Communications (NYSE: VZ) is off nearly 4% in the past 12 months. As a defensive telecom stock, VZ could benefit from a catch-up rally if the market continues higher… or a flight to safety if investors grow nervous.

VZ has traded in a range between $52 and $45 for the past year, which puts midpoint support at roughly $48. The recent sideways consolidation between $48 and $50 targets $52 on an upside breakout.

The $52 target is about 6% higher than recent prices, but traders who use a capital-preserving stock substitution strategy could make almost 50% 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 1: 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 VZ trading near $48.90 at the time of this writing, an in-the-money $45 strike call option currently has about $3.90 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 73.

Rule 2: 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 VZ Jan 45 Calls at $4.75 or less.

A close below $46 in VZ 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 $475 or less paid per option contract. The upside, on the other hand, is unlimited. And the January options give the bull trend six months to develop.

This trade breaks even at $49.75 ($45 strike plus $4.75 options premium). That is less than $1 above VZ's recent price. If shares hit the $52 target, then the call option would have $7 of intrinsic value and deliver a gain of almost 50%.

Action to Take -->
-- Buy VZ Jan 45 Calls at $4.75 or less
-- Set stop-loss at $2.35
-- Set initial price target at $7 for a potential 47% gain in six months

This article was originally published at ProfitableTrading.com:
Lagging Blue Chip's Catch-up Rally Could Return Almost 50%

By using a similar options strategy, my colleague Amber Hestla is generating payments of $1,047, $2,435 and $3,410 (and sometimes more) from nearly any stock -- including ones you may already own. This free report explains everything, including names and tickers.

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.