Paper, pens and file folders are big business. And the recently announced merger of the No. 2 and No. 3 office-supplies chains, Office Depot (NYSE: ODP) and OfficeMax (NYSE: OMX), should provide a sense of clarity that could help No. 1 Staples (Nasdaq: SPLS).
Shares of Office Depot and OfficeMax have had significant recoveries from their extreme lows, but the execution of the double team on Staples may not be easy. Staples stands to gain from any missteps by the combined company with a renewed focus on a sole competitor.
Staples' stock has traded in a range between $26 and $10 a share for the past five years, with a modest bounce from the lows to the $14 level in the past few months. The target sits at $18 on a recovery to the halfway point of the multi-year decline.
The $18 target is about 26% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could make 60% on a move to that level.
One major advantage of using long call options rather than buying the stock outright 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.
An option's strike price is the level at which the options buyer has the right to purchase the underlying stock or exchange-traded fund (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.)
Any trade has a 50/50 chance of success. Buying in-the-money options increases that probability. 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.
With Staples stock trading at about $14.25 at the time of this writing, an in-the-money $10 strike call currently has $4.25 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.
With these rules in mind, I would recommend the SPLS Jan 2014 10 Calls at $5 or less.
A close below $10 in the stock 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 $500 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend almost a year to develop.
This trade breaks even at $15 ($10 strike plus $5 option premium). That is less than $1 above Staples' current price. If shares hit the upside breakout target of $18, then the call options would have $8 of intrinsic value and deliver a gain of 60%.
Action to Take --> Buy SPLS Jan 2014 10 Calls at $5 or less.
Set stop-loss at $2.50. Set initial price target at $8 for a potential 60% gain in 11 months.
This article originally appeared on ProfitableTrading.com:
The Reigning Office Supply King Could Deliver 60% Gains by 2014