The sharp pullback that began at the end of November has found support at the $66 halfway range of the 2012 highs near $75 to lows near $57. The strong uptrend remains intact with a 60%-plus rally from the 2011 lows at $46 per share to the November highs.
Filling the price gap on the charts and a breakout at the $75 peak could send prices to $84. The two-year support sits at $60, just below the lows of the current sell-off, as a larger support to lean on.
The $84 target is more than 25% higher than current prices, but traders who use a stock substitution strategy could make triple-digit returns 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 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 YUM trading at about $66.25 at the time of this writing, an in-the-money $57.50 strike call currently has $8.75 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 YUM Jan 2014 57.50 Calls at $12 or less.
A close below $60 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 $1,200 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend more than a year to develop.
This trade breaks even at $69.50 ($57.50 strike plus $12 option premium). That is a little more than $3 above YUM's current price. If shares hit the upside breakout target of $84, then the option would deliver a gain of more than 100%.
Action to Take --> Buy YUM Jan 2014 57.50 Calls at $12 or less. Set stop-loss at $6. Set initial price target at $26.50 for a potential 121% gain in 13 months.
This article originally appeared on TradingAuthority.com:
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