Pfizer's (NYSE: PFE) 2004 peak approached $40 before a multi-year decline. But shares have been on a strong recovery from 2009 lows below $12 a share to nearly double that price today. The combination of the powerful trend and low volatility make PFE a great candidate for a stock substitution play.
A technical continuation pattern known as a consolidation wedge between $23 conservatively (really back to the $21 base) and $24.50 sets Pfizer up for an upside breakout. Based on the pattern, the first target is $26 and the second target is $28. The halfway point of the 52-week price action has support at $20 to keep the uptrend intact.
The actual Pfizer shares are inexpensive compared with some other stocks, but long-term money potentially tied up in the stock play could be put to better use. A long Pfizer call can provide staying power in a potential larger trend extension, and the maximum risk is the premium paid.
One major advantage of using long options rather than buying shares is putting up much less money 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 ever pay off.
For example, with Pfizer trading around $23.90 at the time of this writing, an in-the-money $20 strike option currently has $3.90 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 Pfizer March 2013 20 Call for $4.25 or less. A close in the stock below $20 on a weekly basis or the loss of half of the option premium would trigger an exit.
With this trade, the maximum loss is limited to the $425 or less paid per option contract. The upside, on the other hand, is unlimited. This trade breaks even at $24.25 at expiration ($20 strike plus $4.25 option premium). That is less than 50 cents above Pfizer's current price.
Essentially, you own the stock from $20 with over six months of time for any bullish development with absolutely limited risk to the $425 paid for the option.
Action to Take --> Buy Pfizer March 2013 20 Call at $4.25 or less. Set stop-loss at $20 for Pfizer. Set initial price target at $26 for Pfizer.