There has been a break in the news cycle as Europe has been quiet for a few weeks, but that is about to change. The next summit of European leaders is scheduled for mid-October, but politicians are already posturing so there could be market-moving news before then.
The European Central Bank (ECB) has promised to do whatever is needed to save the euro. More details are expected this week, but ECB actions will probably include bailing out Spain, especially after that country's finance minister announced this weekend that he sees a rescue on the horizon.
Bailouts have been good for stocks in the past few years. The bear market that drove U.S. stocks down by 25% in the first three months of 2009 was stopped when the Federal Reserve began aggressively bailing out the credit market. That pattern has repeated several times, and I think we will see a sharp move up in European stocks as the ECB takes action.
One way to profit from that news is with Telefonica (NYSE: TEF), a telephone company headquartered in Spain with operations in Europe and Latin America. Although it is considered a Spanish company, Telefonica gets only 25% of its revenue from Spain. Even a collapse of the Spanish economy should not significantly harm Telefonica.
The company is likely on the watch list of many value investors. It's trading at a price-to-earnings (P/E) ratio of about 11 and has a price/earnings-to-growth (PEG) ratio of 0.5. Many value investors consider a PEG ratio of less than 1 to be a bargain. But they may be waiting for specific details from the ECB on what the central bank will do for Spain, and that news could come soon.
Based on the chart, TEF looks like a high-risk, low-reward trade. Prices have been in a trading range since May, and an upside breakout from that range gives us a target of about $15, a potential gain of about 9%. The stop-loss level based on the trading range is near $11, which makes the potential risk on the trade more than 20%.
But there is an options strategy that creates a very high potential reward with less risk: Buying the TEF March 2013 12.50 Calls for $1.50 or less.
The price you pay to buy an option is the maximum risk on the trade. In addition, the call option eliminates the risk of being stopped out in the event of a large downside gap. If traders are disappointed by the ECB or policy actions, then a sell-off could lead to an opening gap that potentially pushes the price below the stop level set on the stock trade and an even larger loss for those owning the stock.
Action to Take --> If TEF moves above $14 before March, then the option will have intrinsic value. If Telefonica reaches $15, then the call would be worth $2.50 and traders would have a profit of 67%. Risk on the trade is limited to $150 per option contract. This makes the March 2013 $12.50 calls on TEF a way to trade potential good news out of Europe, Spain in particular, with low risk.
Buy TEF March 2013 12.50 Calls at $1.50 or below. Do not use a stop-loss (trade only what you can afford to lose). Set initial price target at $2.50 for a 67% gain.