While the S&P 500 and Dow have rallied to five-year highs, the technology sector has lagged, and is currently sitting about 4% below the fall peak. The PowerShares QQQ Trust (Nasdaq: QQQ), an exchange-traded fund (ETF) that tracks the Nasdaq 100, could provide a diversified way for investors to profit while this out-of-favor sector plays catch up.
One reason I like this fund is the exposure it offers to Apple (Nasdaq: AAPL), which accounts for a whopping 15% of the index weight. AAPL is more than 35% off its September highs, but when the stock stabilizes and snaps back, QQQ will rise with it.
QQQ's recent month-long range between $68 and $66 targets $71 on a breakout, which would be a new 52-week high for the ETF. A full "V" recovery rally projects a much higher target of $78. The $64 level is an important year-long pivot point, and is just below the $65 support midpoint of the 2012 highs to lows.
The $71 target is about 6% higher than current prices, but investors who use a capital preserving, stock-substitution strategy could make more 50% 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.
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 QQQ trading at about $67 at the time of this writing, an in-the-money $64 strike call currently has $3 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 QQQ June 64 Calls at $4.50 or less.
A close below $64 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, then the maximum loss is still limited to the $450 or less paid per option contract. The upside, on the other hand, is unlimited. And the June options give the bull trend almost five months to develop.
This trade breaks even at $68.50 ($64 strike plus $4.50 option premium). That is about $1.50 above QQQ's current price. If shares hit the modest upside breakout target of $71, then the call options would have $7 of intrinsic value and deliver a gain of more than 50%.
Action to Take --> Buy QQQ June 64 Call at $4.50 or less. Set stop-loss at $2.25 and set an initial price target at $7 for a potential 56% gain in four and a half months.
This article originally appeared on ProfitableTrading.com:
"This Out-of-Favor Sector Could Make Traders 50%-Plus"