The pullback this week in Teva Pharmaceutical Industries Limited (NYSE: TEVA) is an opportunity to use the power of options for a capital-preserving, stock substitution strategy. We're seeing bullish divergence in Teva stock options' implied volatility with less fear on the latest price decline to new lows. This can mark a price bottom, as the emotional selling extreme may have been exhausted sellers.
A failed test of the multi-year lows from 2009 and 2011 has formed a bullish base over the past few weeks. The extreme low at $35 a share from two years ago is a point the stock can lean on for support.
A range has been established between $42 a share and $38 since May, which targets $46 on a breakout of the trading channel. That level is near the stock's 52-week high and the technical breakdown point. As a rule, markets often return to breakouts to test trends.
The $46 target is about 21% higher than current prices, but traders who use a stock substitution strategy could make more than four times that amount on a move to that level.
One major advantage of using long call options rather than buying shares 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 (exchange-traded fund) 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 Teva trading at about $38 at the time of this writing, an in-the-money $30 strike call currently has $8 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 Teva Jan 2014 30 Calls at $8.50 or less.
A close below $35 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 $850 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend a year to develop.
This trade breaks even at $38.50 a share ($30 strike plus $8.50 option premium). That is about 50 cents above Teva's current price. If shares hit the upside breakout target of $46, then the options would deliver a gain of almost 90%.
Action to Take --> Buy Teva Jan 2014 30 Calls at $8.50 or less. Set stop-loss at $4.25. Set initial price target at $16 for a potential 88% gain in one year.
This article originally appeared on ProfitableTrading.com:
Bullish Breakout in This Pharma Stock Could Deliver 88% Profits